What is the People’s Bank of China up to?
The PBoC surprised the market on Tuesday by changing the way the daily fixing rate for the renminbi is calculated, which effectively weakened the currency against the US dollar by 1.9 percent from the day before.
Starting Aug. 11, the daily fixing is based on the previous day’s market closing rate as quoted on the China Foreign Exchange Trading System, the onshore foreign exchange market made up by 35 large banks designated by the monetary authorities.
Before the change, the daily fixing rate was calculated as the moving average of the closing rates in the past 10 trading days.
The PBoC has retained discretion to adjust the fixing rate according to market demand and supply conditions.
This means the authorities can still influence the daily initial trading of the renminbi through foreign exchange market intervention.
Nevertheless, the move allows the renminbi’s direction to be influenced more by market forces than before.
As part of genuine foreign exchange reform, the PBoC should have tied the daily fixing rate to the previous day’s closing rate long ago — instead of just widening the trading band — to give the market more influence on the movement of the renminbi.
Now that the PBoC has finally done that, it will give Beijing an argument to take to the International Monetary Fund showing that China is increasing marketization of the renminbi and accelerating foreign exchange reform — which should make the renminbi worthy to be considered as a component of the IMF’s special drawing rights currency basket.
Crucially, the move is not a harbinger of a policy shift toward devaluing the renminbi, because devaluation would not help Chinese exports much, as empirical evidence shows the renminbi exchange rate does not have a significant effect on Chinese export growth.
Nor would devaluation help growth in gross domestic product much, as net exports have been a drag on growth and not a contributor since 2009.
Devaluation could also lead to destabilizing capital outflows due to an expectation of further devaluation and exacerbate the financial burden of the Chinese firms with large and unhedged foreign currency (mainly US dollar) debt.
Fundamentally, the opening of China’s capital account is forcing it to choose between retaining monetary autonomy (that is, controlling the interest rate) and controlling the exchange rate.
Clearly, Beijing is choosing to retain monetary autonomy by letting go of the exchange rate.
It is the right choice given China’s large continental economy and will allow it to conduct more effective monetary policy for economic management than small economies (like Hong Kong and Singapore), where international factors often overwhelm the power of domestic monetary policy.
What this means is that opening the capital account is forcing China to pursue a major overhaul of its economic, financial and policy frameworks, and the PBoC’s move to change the daily fixing regime is another step in making the changes.
It is also a move conducive to renminbi internationalisation and economic restructuring over the medium to long term.
Given the prevailing short-term negative sentiment toward the renminbi, depreciation pressure is likely to mount.
But the PBoC will likely resist any major fall in the exchange rate to the US dollar — and it certainly has the firepower to do so — as that could create a vicious cycle of depreciation/devaluation expectations, risking massive capital outflow.
However, the move does signal a minor policy shift from the previous “stable renminbi with a strong bias” to a “stable renminbi with a weak bias”, the bias being driven by market sentiment.
Short-term renminbi depreciation would put downward pressure on currencies in the region, as our research shows an increasing number of Asian currencies have been closely tracking the movement of the renminbi in recent years.
The medium- to long-term outlook for the renminbi under a more flexible trading regime will mean more volatility for the currency.
But this is a step forward toward making trading in the renminbi more like that in a normal international currency.
The ultimate direction of the renminbi exchange rate will increasingly be determined by capital flow factors other than trade and foreign direct investment flows.
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