Renminbi Devaluation Tests China’s Commitment to Free Markets
Gabriel Wildau in Shanghai
Financial Times
Depending on who you ask, China’s move to let its currency depreciate is either a milestone for market reform or a sharp escalation of a currency war waged by government planners desperate to rescue a sputtering economy.
China’s central bank has done its best to support the first interpretation. In addition to pre-empting accusations of competitive devaluation, this framing strengthens the case that a more flexible renminbi deserves the International Monetary Fund’s endorsement as an official reserve currency.
Critics counter that China’s appeal to market forces is opportunistic. The Communist party likes to unleash market forces when they happen to align with its policy goals, they say, but will quickly revert to daily intervention when conditions shift.
Proponents of the market reform interpretation point out that China’s devaluation does not follow the usual currency war script. Unlike so-called Abenomics in Japan, for example, China’s central bank is not creating money and selling it into the market. Instead, the People’s Bank of China weakened the renminbi simply by unleashing depreciation pressure that had been building for months but that previous central bank intervention had held in check.
“In the current environment, giving the market a greater say in determining the exchange rate inevitably means allowing some depreciation,” says Julian Evans-Pritchard, China economist at Capital Economics.
“Giving in to downward market pressure in order to push ahead with financial reform is a far cry from embarking on a competitive devaluation.”
The central bank publishes a daily guidance rate for the renminbi each morning and allows banks to trade the currency by no more than 2 per cent above or below that level.
Since November the spot rate has traded weaker than the PBoC’s guidance every day. That is clear evidence that market forces — notably unprecedented capital outflows — have weighed on the renminbi but that the PBoC’s artificially strong reference rate prevented depreciation.
Two straight quarterly drops in official foreign exchange reserves indicate that the central bank has also sold dollars directly to counteract depreciation pressure.
But on Tuesday the PBoC abruptly set its guidance 1.9 per cent weaker, the biggest one-day fall since the establishment of China’s modern foreign exchange market in 1994. That allowed the spot rate to fall the same amount without violating the 2 per cent limit. No direct renminbi selling by the PBoC was necessary.
In its accompanying statement, the central bank said it would henceforth set the guidance rate mainly based on the previous day’s spot close — in effect, a promise to let the market dictate the guidance, rather than vice versa. Thus an unprecedented devaluation was framed as an exercise in laissez-faire.
Now, however, the question is whether the PBoC has opened a Pandora’s box. Authorities who thought they signed on for a modest 5 per cent slip may soon find that the market’s appetite is for a 10-15 per cent plunge.
Analysts say the central bank probably viewed a large and sudden devaluation as preferable to a slow-motion slide, which risks entrenching long-term depreciation expectations. Such expectations could create a vicious cycle of capital outflows leading to further devaluation.
The PBoC took take aim at such expectations on Wednesday, saying “there is no basis for persistent depreciation of the renminbi”. The risk is that such assurances fail to persuade the market.
The challenge of managing expectations posed a dilemma for the PBoC on Wednesday morning: set the reference rate weaker in line with Tuesday’s weaker spot close, making good on the pledge to abide by market principles but fuelling depreciation expectations; or hold the fixing steady, nipping bearish expectations in the bud but backpedalling on market reform. It chose the former, paving the way for another steep fall in the spot rate.
Yet forex traders said on Wednesday they had detected signs that the PBoC was again selling dollars in the market to soften the currency’s fall. After initially falling by as much as 2 per cent, the renminbi rallied strongly in the final hour of trade to close down only 1 per cent.
Thursday’s reference rate was again set near Wednesday’s closing level. But thanks to the late rally, Thursday’s fix was still only a modest 1.1 per cent weaker than the previous day, setting the stage for a more modest decline in the spot rate, which fell 0.8 per cent in early trade.
All this suggests China is likely to continue the two steps forward, one step back approach to market reform it has pursued for nearly four decades. Reform will continue, but too slowly for critics. Forex intervention will diminish but not disappear.
“We think it unlikely that the Chinese government will let only market momentum drive the renminbi exchange rate from now on, as that can be quite destabilising,” said Tao Wang, chief China economist at UBS. “How China sets its daily fixing and manages FX market flows in the next few days will be very telling.”
Financial Times
Depending on who you ask, China’s move to let its currency depreciate is either a milestone for market reform or a sharp escalation of a currency war waged by government planners desperate to rescue a sputtering economy.
China’s central bank has done its best to support the first interpretation. In addition to pre-empting accusations of competitive devaluation, this framing strengthens the case that a more flexible renminbi deserves the International Monetary Fund’s endorsement as an official reserve currency.
Critics counter that China’s appeal to market forces is opportunistic. The Communist party likes to unleash market forces when they happen to align with its policy goals, they say, but will quickly revert to daily intervention when conditions shift.
Proponents of the market reform interpretation point out that China’s devaluation does not follow the usual currency war script. Unlike so-called Abenomics in Japan, for example, China’s central bank is not creating money and selling it into the market. Instead, the People’s Bank of China weakened the renminbi simply by unleashing depreciation pressure that had been building for months but that previous central bank intervention had held in check.
“In the current environment, giving the market a greater say in determining the exchange rate inevitably means allowing some depreciation,” says Julian Evans-Pritchard, China economist at Capital Economics.
“Giving in to downward market pressure in order to push ahead with financial reform is a far cry from embarking on a competitive devaluation.”
The central bank publishes a daily guidance rate for the renminbi each morning and allows banks to trade the currency by no more than 2 per cent above or below that level.
Since November the spot rate has traded weaker than the PBoC’s guidance every day. That is clear evidence that market forces — notably unprecedented capital outflows — have weighed on the renminbi but that the PBoC’s artificially strong reference rate prevented depreciation.
Two straight quarterly drops in official foreign exchange reserves indicate that the central bank has also sold dollars directly to counteract depreciation pressure.
But on Tuesday the PBoC abruptly set its guidance 1.9 per cent weaker, the biggest one-day fall since the establishment of China’s modern foreign exchange market in 1994. That allowed the spot rate to fall the same amount without violating the 2 per cent limit. No direct renminbi selling by the PBoC was necessary.
In its accompanying statement, the central bank said it would henceforth set the guidance rate mainly based on the previous day’s spot close — in effect, a promise to let the market dictate the guidance, rather than vice versa. Thus an unprecedented devaluation was framed as an exercise in laissez-faire.
Now, however, the question is whether the PBoC has opened a Pandora’s box. Authorities who thought they signed on for a modest 5 per cent slip may soon find that the market’s appetite is for a 10-15 per cent plunge.
Analysts say the central bank probably viewed a large and sudden devaluation as preferable to a slow-motion slide, which risks entrenching long-term depreciation expectations. Such expectations could create a vicious cycle of capital outflows leading to further devaluation.
The PBoC took take aim at such expectations on Wednesday, saying “there is no basis for persistent depreciation of the renminbi”. The risk is that such assurances fail to persuade the market.
The challenge of managing expectations posed a dilemma for the PBoC on Wednesday morning: set the reference rate weaker in line with Tuesday’s weaker spot close, making good on the pledge to abide by market principles but fuelling depreciation expectations; or hold the fixing steady, nipping bearish expectations in the bud but backpedalling on market reform. It chose the former, paving the way for another steep fall in the spot rate.
Yet forex traders said on Wednesday they had detected signs that the PBoC was again selling dollars in the market to soften the currency’s fall. After initially falling by as much as 2 per cent, the renminbi rallied strongly in the final hour of trade to close down only 1 per cent.
Thursday’s reference rate was again set near Wednesday’s closing level. But thanks to the late rally, Thursday’s fix was still only a modest 1.1 per cent weaker than the previous day, setting the stage for a more modest decline in the spot rate, which fell 0.8 per cent in early trade.
All this suggests China is likely to continue the two steps forward, one step back approach to market reform it has pursued for nearly four decades. Reform will continue, but too slowly for critics. Forex intervention will diminish but not disappear.
“We think it unlikely that the Chinese government will let only market momentum drive the renminbi exchange rate from now on, as that can be quite destabilising,” said Tao Wang, chief China economist at UBS. “How China sets its daily fixing and manages FX market flows in the next few days will be very telling.”
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