The RMB exchange rate has always been in the process of reform. On August 11, China’s central bank unexpectedly announced its perfection of a midpoint rate determination mechanism, which takes as main references the closing rate of the previous day, the demand and supply of the foreign exchange-rate market as well as the exchange rate of the world’s major currencies. Affected by this, the offshore RMB spot rate against the dollar fell sharply by 1.87%, the biggest one-day fall since the official and the market RMB exchange rate converged in 1994, causing a ripple effect in the global market.
However, this exchange-rate fall should not be interpreted as normal currency depreciation. The formation mechanism of the RMB exchange rate has been the key factor that impeded the openness of the Chinese capital account, RMB internationalization and the enhancement of monetary sovereignty. Because of the previous non-market-oriented determination of the midpoint RMB exchange rate and the restricted floating ranges of the RMB exchange rate, that rate not only failed to reflect the real market supply and demand but also the RMB’s peg to the US dollar put China’s central bank in a passive dilemma. Under the major differentiation of the Chinese and the US financial cycle and the currency cycle, the continued passive appreciation of the RMB against the US dollar and other currencies has been a heavy burden for Chinese economy. Thus, it is imperative to break the “spell” of unilateral and passive appreciation, improve the RMB exchange rate formation mechanism and enhance the flexibility of the RMB exchange rate.
Data show that since the first RMB exchange rate reform from July 21, 2005 to August 10, 2015, the RMB had appreciated 29.3% against the US dollar, 47.98% against the euro and 49.26% against the Japanese yen. The real effective and nominal RMB exchange rate indexes in July 2015 all rose sharply, both creating a new high in history. The real effective RMB exchange rate index grew by 4.57% while the nominal RMB exchange rate index rose by 4.88%. Among the 61 currencies monitored by the Bank for International Settlements, the growth of nominal and real effective RMB exchange rates ranked first and second respectively.
So, the adjustment of an RMB reference rate setting is an important step towards a market-oriented exchange rate mechanism, the significance of which cannot be simply evaluated in terms of immediate interests. From the perspective of policy effect, the reform of RMB reference rate setting mechanism weakened RMB’s peg to the US dollar. Although de-pegging the US dollar can enlarge the floating range of the RMB exchange rate, it is different from the continued currency depreciation in nature.
On the one hand, the new policy of RMB exchange rate reform helps to reduce administrative interference of the exchange rate, to increase exchange rate flexibility and to eliminate the “two-tiered system” (another trading rule and exchange rate that are formed in Hong Kong and overseas “offshore market” and different from the Chinese mainland’s “onshore market” trading rule and exchange rate), allowing the tightly controlled RMB to make a more flexible response to the market. As the next step of the exchange-rate reform, China’s central bank is likely to enlarge the onshore exchange rate market entry for the qualified foreign entities in the future, strengthen the ties between the onshore and offshore markets and promote the formation of an integrated RMB exchange rate both at home and abroad.
On the other hand, the exchange rate reform can also help eliminate the policy distortion of the reference exchange rate and make the midpoint exchange rate between the RMB and the US dollar close to a market equilibrium rate. Particularly during the reform, the choice of a one-time big depreciation rather than a sustaining depreciation fully shows that China central bank took a short-term active measure in its long-term passiveness. It is a correction of excessive RMB appreciation in the short-term to get the RMB back to the reasonable currency value.
Besides, marching towards a market-determined exchange rate mechanism is also a premise and precondition for the RMB to join the IMF Special Drawing Rights (SDR). IMF annual report of Article IV Consultation on China’s economy points out that the real effective RMB exchange rate sharply appreciated over the previous year and the current RMB value was no longer underestimated.
All reforms will run risks and pay the price. The new RMB exchange rate reform policy is no exception. The direct impact is the capital outflow and the increase of foreign-debt risk caused by currency depreciation. Data show that, in July, Chinese financial institutions’ caliber funds outstanding for foreign exchange dropped by 249.1 billion RMB, the central bank’s caliber funds outstanding for foreign exchange dropped by 308 billion RMB. Judging from the absolute outflow, the two leading caliber funds for foreign exchange created the biggest monthly outflows in history. Meanwhile, the fast RMB depreciation also greatly increased the risk of Chinese overseas debt. At the end of 2014, the total Chinese foreign debt, valued at $4,632.3 billion, rose by more than $230 billion within several days because of the RMB depreciation.
China’s new exchange-rate reform must constantly obtain credibility without the short-term utility. From the monetary point of view, considering the exchange-rate market supply and demand, and the exchange rates of the IMF basket of currencies, guiding the market anticipation to maintain the RMB exchange rate stability are the main goals of China’s central bank. China will neither be a follower of a “global currency war” nor let its currency continue to depreciate sharply. A long-term stable RMB exchange rate with a two-way volatility is conducive to maintaining the financial asset price, to preventing a large-scale capital outflow, to controlling foreign-debt risk, to reducing the cost and burden of debt financing and to stabilizing economic growth anticipation. It conforms to the present Chinese strategic interests and very much to the long-term goal of RMB internationalization.