One Step Backwards could be Two Steps Forward for the Yuan

The redback’s managers excel in catching the currency markets off-guard. In January 1994, China unified its dual exchange rate system by aligning the official rate to the market rate and pegging the yuan to the dollar tightly thereafter. Since 85 percent of yuan trades occurred at market rates at the time, the de facto overall devaluation was a mere 5.25 percent — not the 35 percent that is commonly (mis)quoted.

The redback’s managers excel in catching the currency markets off-guard. In January 1994, China unified its dual exchange rate system by aligning the official rate to the market rate and pegging the yuan to the dollar tightly thereafter. Since 85 percent of yuan trades occurred at market rates at the time, the de facto overall devaluation was a mere 5.25 percent — not the 35 percent that is commonly (mis)quoted. Eleven years later, on 21 July 2005, the People’s Bank of China (PBoC) surprised global financial markets by pushing the yuan up by 2.1 percent — in effect, removing the hard peg and transitioning to a crawling peg-type regime that, by and large, used the dollar as its central tendency.

On 11 August 2015, the People’s Bank of China surprised the markets yet again by devaluing the yuan by 1.9 percent against the US dollar. More importantly, it announced a change in the procedure by which it sets the daily reference rate, which determines trading levels in the onshore yuan market. The reference rate will take greater account of market factors and will be set at a rate equal to ‘the closing rate of the inter-bank foreign exchange market on the previous day’ and not left wholly to the discretion of the central bank.

This shift to a managed float currency regime should not have caught markets entirely by surprise. The yuan had depreciated by 2.5 percent against the dollar in 2014 and repeatedly tested the weak side of its daily trading band during early 2015 trading. The central bank has effectively also been running a two-way de facto managed floating regime for some time. During the 57 trading days of the first quarter of 2015, the yuan appreciated on 24 days and depreciated on the other 33.

So why now and what were the key drivers for the move?

The proximate driver was a series of near-term macroeconomic and financial data that underscored the softness of domestic demand. Most prominently, a National Bureau of Statistics release on 10 August showed that producer prices had suffered their biggest year-on-year decline in July since 2009. The PBoC had already lowered interest rates four times since November 2014, cut banks’ reserve requirement ratios, and relaxed local governments’ financing conditions. Devaluing the yuan was among the few available options remaining within the monetary policy toolkit.

The yuan was also at risk of overvaluation. It linked tightly to the dollar, which is strengthening on the back of an anticipated Federal Reserve rate hike later in 2015. The resultant domestic disinflation and capital flow volatility did not help either.

But the most important driver was the imperative to signal to the international economic community that China has formally — and irrevocably — graduated to a managed float currency regime. It is flexible to two-way movements based on market signals. Later in 2015, the IMF Executive Board is due to formally review the composition and valuation of its Special Drawing Rights (SDR) basket. Including the renminbi in the SDR basket will be an important marker of the distance travelled on the road to full internationalisation as well as the currency’s rise, in time, to the ranks of one of two (or three) key global reserve currencies within the 21st century international monetary system.

The renminbi is the only currency not in the SDR basket that meets the basket’s export criterion: belonging to a country that plays a central role in the global economy. And on 35 of the 40 items in the IMF’s classification of capital account transactions, the renminbi is fully or partially convertible. But it remains to be seen if this is sufficient to meet the SDR’s threshold of a ‘freely usable’ currency — that is, one that is widely used to make payments for international transactions and is widely traded in the principal exchange markets. Formally committing to two-way flexibility cannot hurt the renminbi’s chances.

There should be no misgivings regarding the PBoC’s commitment to a more market-determined exchange rate. The instances of change in China’s currency regime have been few and far between, and each instance has resolutely embraced a progressively liberalising tendency. China’s currency managers too are aware of the need for two-way flexibility with the gradual opening of its financial markets. The combination of open financial markets and rigid exchange rates has typically been a disastrous cocktail for developed and developing countries alike. And Beijing enjoys advantages that other peggers did not have when they liberalised exchange rates — a large foreign reserve buffer and a less liberalised capital account.

While shrill forebodings of a return to ‘currency wars’ are overblown, the outlook for US–China trade quarrels will depend on the pace of the American economic recovery, the Chinese economic transition to a consumption-oriented economy and whether the PBoC will serve as a worthy steward of the yuan’s market-based exchange value. But no virtuous capital expenditure cycle is evident on the US economic horizon, and China is only starting to implement key systemic reforms. On the broader trade front, Chinese and US import volumes have both flat-lined as a share of real GDP.

No such mixed prognosis exists for Asian and other emerging market currencies. In the short term, key currencies that are highly dependent on trade with China will witness heavy capital outflows. But the most consequential outcome of liberalisation will be in the medium term. The renminbi will rise as the key anchor currency for the broader Asian economic zone, and key Asian emerging market economy currencies will co-move with the redback. Before the global financial crisis, six of 10 Northeast and Southeast Asian currencies tended to co-move more with the dollar. Since then, seven of 10 co-move more with the renminbi. As China becomes a more consumption-driven economy and the final destination for more of the region’s manufactured goods, the magnitude of these co-movements will deepen.

A small step backwards for the yuan might yet prove the biggest leap forward in Asian economic, trade and financial regionalism in the years and decade ahead.

China sheds its dollar shackles is republished with permission from East Asia Forum