The Chinese renminbi depreciated 2.5 per cent against the U.S. dollar in 2014. It was the largest annual fall since 2005, when Beijing timidly started loosening its tight dollar peg. In the first few weeks of 2015, the Chinese currency has repeatedly tested the weak side of its daily trading band, despite attempts by the People’s Bank of China (PBoC) to signal a steadier bilateral renminbi-U.S. dollar rate via its daily fixing (Figure 1, left panel).
What has led to the changing fortunes of the renminbi? Has the PBoC intentionally pursued a weak currency policy to boost a weaker Chinese economy, as some have alleged? What lies ahead for the currency in 2015?
There are several possible factors leading to the most recent bout of weakness in the renminbi–U.S. dollar rate.
|The RMB daily trading band and the USD Index||Figure 1|
|RMB per US$1||The USD Index and the CNY-USD Rate 2|
|1 The daily trading band was ±1% before March 2014 and ±2% afterwards.||2 the USD index is the US Fed narrow basket index. The CNY-USD is number of RMB per USD.|
The most obvious culprit is the broad strength of the U.S. dollar. Since the start of 2014, both the euro and yen have weakened by 15 per cent against the dollar. In fact, most advanced and emerging currencies fell vis-à-vis the dollar, as can be seen from the rising DXY (Figure1, right panel). Consequently, the Chinese ‘redback’ has also weakened slightly against the almighty U.S. ‘greenback’, though the renminbi is still outperforming most other currencies. According to Bank for International Settlements (BIS) statistics, the renminbi gained some 7 per cent in effective terms in 2014.
Monetary policy divergence between China and the U.S. is another factor. Whereas the U.S. Federal Reserve is expected to start raising its policy rate and has stopped further unconventional (net) bond buying, the PBoC has embarked on a cycle of monetary easing. Hence the anticipated interest rate differential between the two currencies is narrowing.
There is now some debate about underlying currency valuation of the renminbi. Over the past decade, the renminbi has gained 50 percent on a broad real effective basis. Even allowing for fast Chinese productivity growth, there are now questions about whether the renminbi is fairly valued or even overvalued. Comparing the prices of the same items on the American and Chinese supermarkets, one often finds many daily goods more expensive in China than in the U.S. At least, the once broad-based market consensus of an undervalued renminbi is gone.
Market participants have also become worried about a seemingly more stressed Chinese financial system. Rising corporate leverage, high local government debts, and expanding shadow banking, just to name a few worries. As the exchange rate is one of the most important financial asset prices, how can one expect an ever-stronger renminbi on top of a more fragile Chinese financial sector? It makes little sense to dread Chinese shadow banking and to preach meaningful renminbi appreciation at the same time.
Finally, the PBoC appears to have taken a more hands-off approach towards managing the redback. Since early 2014, it has intervened less in the foreign exchange market and widened the daily trading band in March 2014 from ±1 percent to ±2 percent against the U.S. dollar. A growing offshore renminbi market also means risk sentiment playing a bigger role in renminbi exchange rate dynamics. The offshore renminbi turnover is likely to have more than doubled in the past two years, according to my estimate.
A mighty U.S. dollar, monetary policy divergence, currency valuation concerns, and less PBoC intervention all combine to sway currency expectations, raise volatility, and narrow interest rate differentials. Thus the implied Sharpe ratio — which measures risk-adjusted returns in investment portfolios — declines, prompting an increase in Chinese corporate hedging of dollar liabilities, with rising dollar deposits and a more rapid extinguishing of Chinese corporate dollar debts. Added to demand for U.S. dollars have been the growing overseas acquisitions by Chinese companies.
In balance-of-payments terms, the fourth quarter of 2014 saw the largest Chinese capital outflow in 16 years, and official foreign exchange reserves have fallen steadily since mid-2014, though this is in part due to valuation effects. In short, Chinese demand for U.S. dollars has risen, temporarily weakening the renminbi-U.S. dollar exchange rate.
Thus the modest weakening of the renminbi against the U.S. dollar has not been a deliberate government policy. Indeed, the PBoC was quick to advantage of the transitory easing of dollar strength in late March to signal and encourage the renminbi to firm up against the ‘greenback’ during the course of last March. What the PBoC really wants is a more flexible (or volatile) renminbi with a bigger international role.
What will happen next? It depends a lot on how the PBoC responds to Chinese corporate dollar buying. There are three possibilities.
First, the PBoC could cling more tightly to the dollar peg, just like it did in the 2008 Global Financial Crisis or the 1998 Asian Financial Crisis. The result will likely be a deflationary blow to the Chinese economy in an environment of persistent dollar strength, a ‘PBoC put’ on the renminbi instilled into market expectations and a brief sense of stability. In this case, a looser dollar peg could re-tighten.
Second, the PBoC could take a laissez faire approach, completely stepping back from the currency market to let it clear itself. This would result in sharp exchange rate volatility and even some corporate stress. In this case, the loose dollar peg could vanish fast.
A third and more likely scenario would be for the PBoC to let the renminbi move more freely against the dollar but prepare to lean against the wind by selling dollars out of its massive official reserves from time to time. In this case, the loose dollar peg would start fading gradually.
This last approach makes sense for a number of reasons. In the short term, it would help deliver a warranted Chinese monetary easing by helping to stabilise the effective exchange rate and to facilitate an orderly unwinding of the Chinese corporate carry trade. Some measured drawdown of the huge Chinese official reserves is also healthy. In the longer term, it would help enhance two-way currency flexibility ahead of fuller interest rate deregulation and greater capital account liberalisation. This also helps enhance monetary policy autonomy, which is important for a large economy like China.
This 20-year old dollar peg has served the Chinese economy well as a simple but credible nominal anchor, but its time is up. As the biggest trading nation and second largest economy, China is too big to be anchored to any single currency, even in a loose fashion. Moreover, a dollar peg has often amplified external shocks to the Chinese economy because of the dollar’s safe haven role. Finally, the U.S. no longer welcomes a renewed Chinese peg to its currency and yet demands nothing but ‘one-direction flexibility’.
Just like the song ‘Let It Go’ in the Disney film FROZEN suggests, it’s high time that the PBoC bid this ageing and loose dollar peg farewell.