Since the beginning of this year, the RMB exchange rate has basically stayed near RMB 6.2 to 1 dollar and has slightly appreciated. The situation is roughly the same as I predicted at the end of December 2014. But big changes in three aspects will put the RMB exchange rate at the risk of depreciation in the second half of the year.
First is China’s A-Share market rout and the government’s support of the market. This reflects the serious lag of financial market reform as well as the lag of the marketization reform of the RMB exchange rate. Therefore, China’s stock market turmoil will greatly affect the market process of China’s financial market and China’s financial marketization reform. This will not only cause the adjustment of the whole financial market development strategy but will also cause the adjustment of some existing specific financial policies by the Chinese government. And it will certainly affect the stability of the RMB exchange rate and the adjustment of the existing exchange-rate policy by China’s central bank. If so, exchange-rate policy will be gradually adjusted in the second half of the year.
Second is the high probability of interest-rate hikes by the US Federal Reserve in the second half of the year; basically, this tendency will not change. Recently, Spillover Report, an IMF annual assessment on global financial risk, points out the possibility of the US interest-rate increase in the second half of the year. The US interest rate increase will certainly run counter to the monetary policies of the other major central banks. Meanwhile, it will bring a serious spillover effect to the other countries. Both the developed and newly emerging countries will suffer. In response, China’s government is adjusting its policies to prepare for the possible situation in the second half of the year. Among the policies to be adjusted, the change of the RMB exchange-rate policy could be the focus.
Opinions on Promoting the Steady Growth of Imports and Exports released by the General Office of the State Council on July 24 points out that RMB exchange rate should basically remain stable at a reasonable and balanced level. A market-oriented exchange rate mechanism should be perfected and the rate-floating range should be expanded. The settlement of cross-border trade in RMB should be further facilitated and increased.
The measures in response to the changing RMB exchange-rate policies include a further expansion of the RMB floating range. Recently, China’s central bank has been expanding the floating range. In March, 2013, the bank expanded the range from 1% to 2%. If the RMB exchange-rate floating range is further expanded from the current 2% to 3% or even 5%, it will be more flexible. When the US dollar is in a period of appreciation, the expansion of the RMB floating range also means a moderate release of depreciation pressure of a much stronger RMB against other non-dollar currencies, thus China avoids the predicament of an effective exchange-rate appreciation caused by a lack of exchange rate flexibility and can boost its export.
So, the release of Opinions on Promoting the Steady Growth of Imports and Exports soon raised market expectations of RMB depreciation. That is, the market anticipated that the RMB faced a possibility of a bigger depreciation if its exchange-rate floating range further expands, because this can both promote China’s exports and help change the tendency of a stronger RMB against the US dollar. But, in the present market situation, currency depreciation can have a limited role in increasing China’s exports. For example, since 2014, the RMB has been allowed to depreciate slightly. But export growth did not improve as a result, and capital outflow occurred instead. The Chinese government will possibly focus on increasing the exchange-rate flexibility in its current market-oriented exchange rate reform.
What’s more, the present decision on the exchange rate should also take into account the process of RMB internationalization. For instance, China is striving to join the IMF special drawing rights (SDR) basket and needs to maintain a steady exchange rate. In addition, China’s external debt is as high as $1.6 trillion dollars, with short-term debt accounting for 70%. A substantial RMB depreciation could see a large amount of RMB converted into US dollars to get ready to pay debts, which will be bad for domestic financial stability. Meanwhile, a sharp RMB depreciation will also stimulate the outflow of Chinese capital. These are the factors to be considered in RMB depreciation.
However, because of the recent turmoil in China’s A-Share market, a still very large downward pressure of China’s economic growth and the big change in the international financial market situation, domestic enterprises and residents already had an RMB-depreciation expectation to a certain degree in the first half of the year. Judging from the RMB movement this year, although the exchange rate against the US dollar basically remained stable and appreciated slightly, domestic residents were much more willing to hold US dollars. China’s foreign exchange reserve was cut down by over $149.2 billion in the first half of the year. Although the reduction of foreign reserve could be caused by many factors, it is related to the fact that domestic residents expected RMB depreciation and held more US dollars. In case of further expansion of the exchange rate flexibility, a slight depreciation of the RMB will increase domestic residents’ expectation of RMB depreciation. Under this circumstance, there will be a downward risk of RMB depreciation.
With the changes in domestic and global situations both at home and abroad, any further expansion of the RMB exchange rate flexibility will increase the possibility of RMB depreciation. Although the degree of RMB exchange-rate depreciation could be determined by how the Chinese government weighs the advantages and disadvantages of RMB exchange-rate movement, market forces play a more important role. Investors have to pay close attention to this.