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.
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.
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.
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.
HSBC says: “As more capital flows go through the onshore FX market, the PBoC will find it harder to manage the USD-CNY exchange rate. We have been arguing that Beijing should not fear floating the exchange rate.
“With China’s low currency mismatch and its potential to eventually borrow abroad largely in RMB, the risk of financial instability stemming from currency depreciation and volatility is low and falling.”
RBC rejects the liberalization theory. “PBC still maintains a vice-like grip on where the RMB trades, with the +/-2% daily range adding to its control,” it says.
Instead, RBC suggests China might be pushing through the reforms it needs to enable it to secure inclusion in the basket of currencies used to calculate IMF special drawing rights (SDR), alongside USD, EUR, JPY and GBP.
Many agree this is likely to have been a factor.
“Although it is not explicitly mentioned, it is nevertheless understood that a reserve currency cannot be a highly managed one, which could potentially deviate from its underlying fundamental value thereby resulting in eventual instability,” says HSBC.
HSBC expects additional easing measures in the coming months, to support China’s fragile recovery, with real interest rates having risen significantly for the corporate sector in 2015. This leaves room to lower policy rate further, it says.
“Cuts to the reserve requirement ratio will also be needed to offset the impact of slower FX inflows on base money growth,” adds HSBC, predicting an additional 25 basis points policy rate cut and 200bp reserve ratio cut in 2H 2015.
It is unclear what impact the devaluation will have on the rest of the global economy and China’s regional trading partners. In the immediate aftermath of the announcement, commodities declined broadly across industrial metals and energy.
More interesting is what impact it will have on the Fed’s decision whether to raise rates in September. It has been argued that, by making China’s exports cheaper, the move will have a deflationary impact, which would encourage the Fed to stay its hand to assess the impact of the move.
However, it could also be argued that US monetary policy was already having a deflationary impact by undermining Chinese growth. A yuan devaluation should stimulate growth and offset this impact.
WKU’s Beckworth argues the yuan devaluation need not necessarily cause a deflationary shock if the other central banks ease in turn. “It is likely the Fed will put off its interest-rate hike this year and maybe do more easing if the yuan devaluation truly causes a large deflationary shock,” he says.
In its more immediate vicinity, the move caused other Asian currencies linked to the dollar to lurch higher initially.
“USD-Asia should trade with heightened sensitivity to USD-CNY’s movements, at least until onshore spot finds a better sense of its equilibrium level,” says HSBC, with currencies such as the KRW, TWD and SGD likely to be particularly sensitive to China’s FX policy.
|The future of the RMB:|
BBH did criticise the delivery of the PBoC’s action, if not the action itself. “A steady and gradual move higher in USD/CNY would have been less disruptive than a bigger one-off move,” it says. “We find that a one-off devaluation often leads markets to believe that another one may be delivered, sparking capital outflows and leading to a self-fulfilling prophecy.”
UBS, nevertheless, reckons the announced changes to the exchange-rate regime will improve the “market-driven” quality of the PBoC daily fix, a precondition for the IMF to include the RMB into its SDR reference rate.
Lombard Street Research, which has argued for the past two years, at least, that the RMB needs to be devalued, concludes with a bearish note on the outlook for the global economy: “While the economy desperately needs a weaker currency, joining the other saver economies – Japan and the euro-area – in the global currency war could push the world towards another crisis.
“Yet there is still a slim chance that finally the global financial imbalances are worked out without a 2008-style dislocation. It all depends on whether today’s step-change is the start of a move towards a crawling peg and a more flexible exchange-rate regime or an old-style devaluation.”