A slowing economy has fueled hopes for a possible renminbi devaluation by the People’s Bank of China (PBoC) this year. However, don’t bet on such an outcome. On the contrary, there are good reasons to expect Beijing to keep a stable RMB policy, with a slight appreciation bias driven by market forces.
Since the PBoC squashed the one-way bet on RMB appreciation in early 2014, it has intervened less in the forex market, allowing the currency to enter a “new normal” paradigm in which two-way trading and forex volatility have finally become a reality. Market players have responded by increasing onshore forex hedging activity, which helped weaken the RMB in late 2014 and led to its 2.5 percent decline against the US dollar for the year.
Some analysts have jumped to the conclusion that the RMB would drop sharply in 2015, a view that I don’t share. The market’s forecast for the RMB exchange rate has focused predominately on the RMB-USD cross rate, ignoring the Chinese currency’s trade-weighted exchange rate. But the PBoC’s policy stance towards the trade-weighted exchange rate affects the RMB-USD cross rate directly.
According to BIS estimates, the USD, the euro and the Japanese yen have the biggest weights (21 percent, 18.4 percent and 16.8 percent, respectively) in the RMB estimated currency basket. If the PBoC targets a stable trade-weighted average exchange rate, weakness in the two heavyweights against the USD implies that it would have to devalue the RMB against the USD.
For example, using the BIS’s currency weights, if the euro and yen each depreciates against the USD by 10 percent and other currencies in the basket do not move, the RMB-USD exchange rate would have to be devalued by 3-4 percent to keep the same average exchange rate.
In reality, the euro and yen have each depreciated by more than 8 percent against the USD since late 2014, and other currencies do not stay constant. They have also fallen against the USD. So the PBoC would have to devalue the RMB by more than 3-4 percent against the USD if it were trying to keep its trade-weighted exchange rate from rising.
However, data shows that the RMB’s trade-weighted average exchange rate has risen by more than 32 percent since 2005, while most of its Asian counterparts have dropped. Instead of devaluing the RMB to gain competitiveness, China simply endured its strength, suggesting that it was not targeting the RMB’s trade-weighted average exchange rate. The RMB has indeed become the dearest currency in REER terms among its major Asian peers since 2010.
Evidence also suggests that the PBoC is still targeting the RMB-USD cross rate and that it has no intention to devalue the RMB. The persistent strength of the RMB-USD daily fixing (which is set by the PBoC) on the back of a soft RMB in late 2014 that saw the spot exchange rate trading lower towards the floor of the trading band strongly argues that the authorities were not engineering RMB weakness.
Why does the PBoC want a strong RMB?
A strong currency is the easiest way for Beijing to force economic restructuring in the face of reform resistance. In my view, this is the strongest reason for the PBoC to continue to pursue a strong RMB policy by letting fundamental factors drive a mild appreciation. Other reasons include the risk of capital flight if market expectations are built into RMB devaluation, and a significant global political backlash against such a policy.
The RMB exchange rate is not overvalued, so there is no technical reason to expect it to fall sharply. It has played a minor role in affecting Chinese export growth, which is predominately a function of global demand, and the contribution of China’s net exports to GDP growth has been negative since 2009. All this argues that exchange rate plays only an auxiliary role in helping China’s GDP growth, and the significant costs involved in devaluing it far outweighs the benefits.
In a nutshell, RMB devaluation is not China’s best policy option. The currency’s mild appreciation trend should remain intact in the medium-term, supported by an external surplus, albeit with higher volatility in the “new normal” era. Onshore hedging activity will continue to rise as the PBoC further relaxes control on the currency.
The authorities are still targeting the RMB-USD cross rate, using mild RMB appreciation as a tool to force economic restructuring. They have other policy tools to boost GDP growth if they want to. But Beijing’s policy goal is to strike a balance between slow growth and structural reform progress. So betting on RMB devaluation may not pay off as an investment strategy.
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