On April 23, 2014, the RMB exchange rate against the US dollar was quoted at 6.2489，reflecting a sustained decline and a record low. Up to now, the RMB exchange rate against the US dollar has fallen down at an accumulated rate of 3.12% in 2014, completely offsetting last year’s appreciation gain. The world has reacted differently to this, but most people do not understand why. Now, the key point of the RMB depreciation is how to promote the market reform of the exchange rate. So, the market reform of the RMB exchange rate should first break the pattern of its long-term unilateral appreciation, allowing for a floating exchange rate. It is impossible to have a market-driven RMB exchange rate without depreciation of the RMB or a price fluctuation.
The exchange rate acts as an external price, and its fluctuation means the adjustment of big interests in the market. It affects not only the capital flow in the market, but also the behavioral change of the main economy, as well as the entire market interest pattern. Therefore, this year’s reversed trend of the long-term unilateral RMB appreciation has not only has fought off the RMB appreciation arbitrage behavior prevailing in the market, but has also prevented the big flow of hot money into China, which could hit China’s central monetary policy,. This has not only enhanced the flexibility of the RMB exchange rate, but also means a series of big reforms in the financial market.
First, the government has decided that the main task of financial market reform is the marketization of interest rates and the RMB exchange rate mechanism. Compared with the top-down marketization of interest rates, the reform of the RMB exchange rate mechanism seriously lags behind. This lag not only affects the course of the internalization of the RMB, but also becomes an easy arbitrage tool for both domestic and foreign investors. The trend of the long-term unilateral RMB appreciation should be reversed, and allowing for fluctuating RMB exchange rates is the first step to marketize the exchange rate mechanism. Thus, the Chinese central bank recently employed technological factors to make adjustments (enlarging the space of RMB exchange rate fluctuation) and objective conditions (downward domestic economic growth) to lead the RMB into a depreciation.
Second, after the U.S. financial crisis began in 2008, the Chinese government also adopted an excessive credit expansion policy to guarantee economic growth. However, any excessive credit expansion policy will cause the capital price to spike, thus easily forming a capital price bubble. A spike in the domestic capital price was both related to an excessive bank credit expansion and the long-term sustained RMB unilateral appreciation, as well as a large flow of international hot money into China. In recent years, an RMB appreciation caused a big inflow of hot money and built a lot of credit relationships. Especially in 2013, when economic growth showed a downward trend, the housing price in the Chinese market shot up, a fact related to the big inflow of hot money. The boom of the real estate market caused by overseas hot money is unlikely to persist and is also increasing the risk in the Chinese financial market. Thus, RMB appreciation is an important way to prevent the flow of international hot money into China and lower the risk of the Chinese financial market.
Third, the Chinese central bank took the initiative to actively depreciate the RMB, the underlying purpose of which was to use the exchange rate mechanism to change the behavior of Chinese banks, enterprises and individuals, to change or break the existing social interest structure and pattern, to change the flow of capital held by Chinese enterprises and residents and market expectation, and to promote Chinese industrial restructuring so as to realize the goal of economic sustainability and steady growth. For example, the Chinese government had long realized the serious implications of its economic reliance on real estate. But, because of strong vested interests, corresponding policies were delayed to curb the tendency of a real estate-oriented economy and the huge real estate bubble in China. Even some effective policies were launched to limit the reliance on real estate, but they were unable to be put into effect. The depreciation of the RMB can further prevent the inflow of international hot money, allowing for the devaluation of a RMB denominated housing capital price, increasing the cost of real estate enterprises, and changing the real estate market expectation. There will be a fundamental change in the reversed market expectation, real estate market behavior, capital flow, relationship and pattern of economic interests. This will be the case for the real estate industry as well as for other industries.
Fourth, an RMB depreciation will not only enlarge the space for free fluctuation, but also will mean a more decisive role for the market in the RMB exchange rate. The market mechanism of the RMB exchange rate will gradually form in the process. Meanwhile, it is also an important course towards the internalization of the RMB. Thus, foreign governments will no longer be able to demand a RMB appreciation or depreciation for political reasons. That is to say, if the market determines the RMB exchange rate, it could prevent the US government from being overly critical about the RMB exchange rate.
Above all, the appreciation or depreciation of any currency exchange rate is affected by many factors. If the RMB continues to appreciate without depreciation, the exchange rate of such currency can only retreat from the market farther and farther. So, for the sake of national interests, the Chinese government will depreciate the RMB in order to let the market decide whether the RMB exchange rate should gradually reform with less government interference. Thus, this year’s RMB depreciation is the first step to form a market mechanism of the RMB exchange rate, and is also an important part of China’s entire economic relationship adjustment and interest structure change. Also for the same reason, the size of the RMB depreciation will depend on the national interests and the depth of financial reform.
Yi Xianrong is a Researcher at the Finance Institute of the Chinese Academy of Social Sciences.