On August 11th, 2015, the People’s Bank of China (PBoC), lifted the daily fixing rate for the USD-CNY exchange rate by 1.9%, leading to an effective 1.8% RMB devaluation, the biggest one day move since July 2005, when the PBoC de-pegged the RMB from the US dollar. At the same time, the PBoC also announced that from now on, the daily fixing rate for the RMB-USD will be made with a reference to the previous day’s closing rate, and by taking into account FX market supply-demand and major global currency movements. Put simply, the PBoC moved to make the Chinese currency more market-determined, and right now the market determines that it should be weaker.
Debate in China-watching circles and the mainstream media has been heated: What just happened and why did it happen now? Is Beijing engaging in competitive devaluation aimed at boosting its ailing export sector or is it moving decidedly forward with currency liberalization, as it hopes to see the RMB included in the IMF’s special drawing rights (SDR)?
The main catalyst for the one-off depreciation was most probably the IMF statement the previous week, when the IMF concluded that the RMB trails its global counterparts in major benchmarks and suggested that review of the RMB’s inclusion in the Special Drawing Rights (SDR) mechanism could be delayed. This prompted the PBoC to push forward planned reforms of the currency. The groundwork for such reform was already laid two weeks prior, when on Friday, July 24, the State Council announced its intention to further expand the two-way floating range of the exchange rate. To be sure, it was also politically expedient for the PBoC to launch the reform of the exchange rate when the most likely outcome—a weaker currency—could also support growth. Merchandise exports slumped on a US–dollar basis by 8.3% year on year in July, suggesting that net exports can no longer offer much support to GDP expansion going forward as they did in the first half of 2015.
The one-off devaluation on August 11 was therefore a first step in aligning the daily fixing more closely with the market. The CNY-USD spot exchange rates have gravitated to the weak end of the RMB’s trading band for several months while the PBoC kept the daily fixing rates steady. This has led the RMB to rise against other currencies, by an estimated 10%-15% over the past year.
Indeed, even though a 3% depreciation is an enormous move for the RMB—its largest move this year has been 0.16%—it pales in comparison with other currencies: Over the past year, the euro has fallen by 18% against the US dollar while the Japanese yen has dropped by 22%. Moreover, the RMB has appreciated markedly against almost every currency over the last 18 months: it is still up around 20% against the Euro, 15% against the Yen and 10% against the South Korean Won.
So what now? The 1.6% depreciation on August 12 is probably a taste of things to come: a hybrid model of a market-oriented exchange rate, steered in the right direction by the PBoC. During the course of the day, the RMB fell against the USD given strong market expectations of further depreciation. But the PBoC reportedly intervened in the final minutes of trading, instructing state-owned banks to sell dollars on its behalf. As a result, the RMB gained roughly 1% against the USD in the last few minutes of trading, bringing it down 2.8% since Monday.
Left to the market’s devices, the RMB risks going down a self-fulfilling depreciation spiral: Market sentiment is already negative due to economic slowdown, rising capital outflows and deflationary pressure. And the government mishandling the stock market bailout hasn’t inspired confidence either. So the PBoC is unlikely to leave the RMB completely to the market’s devices. Chinese officials have already indicated that the currency is now more aligned with economic fundamentals, suggesting that a further weakening of the RMB against the USD will be limited. The next few weeks will be important indicators of what Beijing is truly aiming for: A deep depreciation that will boost exports, or a modest devaluation that will correct itself as the RMB moves against a basket of currencies, rather than against the US dollar alone.
Careful what you wish for
China’s international trading partners have long lobbied Beijing to let the currency float freely. These calls were loudest after the global financial crisis, when US senators estimated that China was keeping the RMB artificially low in order to make its exports cheaper globally. As such, they hoped that by letting the RMB float freely, it would appreciate against the USD and restore US export competitiveness. While the currency manipulation debate still surfaces in Washington from time to time, it is now more muted than in the past. And the IMF has already said that the RMB is no longer undervalued. Letting the RMB float more freely now, is perhaps convenient for China in light of its weak trade data, but potentially very inconvenient for the US that might need to rethink the Fed’s expected rate hike in September.
This is another reason for Beijing to limit the extent of RMB depreciation: A rapid and significant weakening would further exacerbate tensions with the United States and other trading partners. Beijing does not need another controversial item on the bilateral US-China agenda, one month before President Xi is planned to meet with President Obama. Furthermore, even though the IMF has welcomed the PBoC’s decision to free the currency and has suggested that it viewed SDR inclusion more favourably, US senators are now raising the currency manipulation flag once again, arguing that this disqualifies the RMB from SDR inclusion. A further weakening of the RMB would make it politically difficult for the Obama Administration to support the RMB’s inclusion in the SDR.
The next few weeks will therefore be key. Most probably, Beijing timed the move to allow the RMB time to find its feet before the September summit, and more importantly, before the IMF review in November. The PBoC has a delicate balancing act over the next month: It must show that it is allowing the RMB to float more freely, without nudging it too forcefully in the right direction.