China stuns markets with sudden currency devaluation

Sid Verma, Solomon Teague
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Everyone knew a revaluation of renminbi was coming sooner or later, yet China's announcement, including reform of the dollar fixing mechanism, caught many off guard. The move left observers debating whether it was stimulating its economy or acquiescing to calls for exchange-rate liberalization.

dollar RMB-R-600

On Tuesday, the People’s Bank of China (PBoC) raised the USD-CNY fixing to 6.2298 from 6.1162, the highest dollar fix in two years. The 1.9% depreciation was framed as part of its reform of the fix that has been on the agenda for some time.

As its trading partners in Europe and Japan have seen their currencies fall, China’s currency has looked increasingly overvalued. Given the competitive gains some of China’s trading partners have seen through currency depreciation, "China’s exporters have been facing an increasingly hostile environment", says Jane Foley, senior currency strategist at Rabobank.

Yet the move came as a surprise, given the "vice-like grip" China has maintained on USD/CNY through stable daily fixings, says RBC. Since April, the USD/CNY fix has been held within a 146-point range, with USD/CNY trading in a tight 131-point range in that period, and the CNY-CNH spread remaining steady.

The PBoC justified the timing of its action, noting the strengthening of USD and the sharp appreciation in the RMB real effective exchange rate. It noted the fixing has shown significant deviation from market spot rate for a prolonged period, weakening its benchmarking function.

As more capital flows go through the
onshore FX market, the PBoC will find it harder
to manage the USD-CNY exchange rate


The PBoC indicated it will henceforth let the market play a bigger role in deciding the exchange rate, and accelerate FX market development by broadening FX products, increasing exchange-rate trading hours by an unspecified amount and introduce qualified foreign investors. It will also move to harmonize onshore and offshore exchange rates.

The fix itself will now be determined more by the previous close in Shanghai, and subsequent changes in the other currencies, though "like much in China, the actual practice may deviate from what appears to be the declaratory policy", warns Brown Brothers Harriman (BBH).

Certainly, there remains considerable uncertainty about how much more flexible the fixing will now be – or how active the PBoC intends to be to stabilize spot prices.

However, BBH says the move is "a vote of confidence in the ability of the financial market to absorb it".

It shows the PBoC is not worried about raising the debt servicing costs of the many Chinese corporates that have borrowed in dollars – another sign of its self-confidence, though as a proportion of China’s GDP and huge foreign-exchange reserves, foreign debt liabilities are limited.

The market has been divided on the motivation behind the move. On the one hand, authorities have sought to promote greater international usage of the RMB, which it has pursued with such initiatives as its central bank currency swap agreements and the Asian Infrastructure Investment Bank. As a result, an unstable RMB might risk undermining these endeavours.

Some see the move in the context of global currency wars, in which central banks weaken their own currencies to gain a competitive advantage: there is no doubt that China’s quasi-peg to the dollar left it facing the prospect of importing increasingly tight monetary policy at a time when its economy needs stimulus.

Conflicting objectives

However, others see it as a step in a longer journey of currency liberalization, allowing the market a greater say in setting the price of renminbi.

FX China chart 2 daily fixing

David Beckworth, associate professor of economics at Western Kentucky University (WKU) and former economist at the US Department of Treasury, says China’s move was almost inevitable because it has been pursuing three conflicting policy objectives, or an "impossible trinity". These are to maintain a fixed exchange rate, exercise discretionary monetary policy and allow free capital flows.

Beckworth says: "If a country tries all three objectives, then economic imbalances will build and eventually give way to some kind of painful adjustment. China was attempting all three objectives to varying degrees."

He therefore believes something had to give, and in this case it was the exchange rate. Furthermore, the devaluation is likely to be merely the first step toward an eventual floating of the yuan, he says.

BBH is also in the exchange-rate liberalization camp, noting the move is "unlikely to have a perceptible impact on the competitiveness of China’s exports". It prefers to accept at face value China’s assertion that the move was merely a move to a more market-based exchange rate.