The People’s Bank of China’s decision to devalue the renminbi by nearly 2 percent Tuesday came as a surprise.
But what is more surprising is the central bank’s announcement it is changing the method of setting the exchange rate for the currency.
Previously, the rate was determined by the PBoC, but under the new method, it will make reference to the previous day’s market close and the daily demand and supply of foreign exchange.
The change means that the renminbi’s exchange rate will be determined more by the market.
This move by the PBoC shows that China has decided to join the currency depreciation bandwagon, following major world currencies such as the euro and the Japanese yen.
It comes as the Chinese economy remains on a weak footing, with exports slowing.
As one of the three traditional growth engines, China’s foreign trade has had a lackluster performance this year.
Total trade dropped 6.9 percent year on year to 11.53 trillion yuan (US$1.9 trillion) in the first half, General Administration of Customs figures show.
Exports edged up 0.9 percent from a year earlier to 6.57 trillion yuan, while imports slumped 15.5 percent to 4.96 trillion yuan.
Given the first-half performance, it is almost certain China will miss its goal of 6 percent growth in foreign trade for this year.
It is not a surprise the government is eager to spur exports by any means.
A weak currency is the most effective and direct way to quickly increase the price competitiveness of Chinese products on the global markets.
The PBoC’s decision to make such a big one-off devaluation of the renminbi also shows that top Chinese policymakers have made up their minds that maintaining economic growth is the most important task for now.
They will not hesitate to leverage the foreign exchange rates to aid the economy, as they often did during economic slowdowns in the past.
However, although the authorities decided to let the currency depreciate, the decline will not be large.
The top policymakers habitually favor stability in the financial markets, as reflected in the unprecedented government intervention to try to reverse the recent stock market rout.
This means that any depreciation of the renminbi will be incremental and small.
It’s likely that the currency will depreciate at an annual rate of about 3-5 percent and will stabilize when China’s economic growth stabilizes.
However, the devaluation is not purely an economic decision.
On the political front, China’s move is a test of the US attitude toward bilateral relations.
President Xi Jinping will visit US President Barack Obama next month.
China’s decision to devalue its currency, which Washington has criticized for years for being artificially undervalued, looks like an attempt to gain China a bargaining chip before the two leaders meet.
The US appears to have adopted a cautious and mild attitude toward the devaluation.
The US Treasury Department has avoided openly criticizing the move.
It said it is too early to judge the full implications and it will continue to monitor how the change is implemented.
This reflects a growing international endorsement of the renminbi’s depreciation following an International Monetary Fund report in May that said China’s currency was “no longer undervalued”, marking a significant shift after more than a decade of criticism of the renminbi’s value.
In addition, the latest currency reform enhances the probability of the renminbi joining the US dollar, the yen, the euro and the British pound in the IMF’s special drawing rights basket.
Although the IMF still wants Beijing to ultimately let its currency float freely, it has called the move to allow a greater role for market forces in setting the renminbi’s exchange rate “a welcome step”.
On the flip side, however, the internationalization of the renminbi might be affected if the currency remains weak in the long term.
Beijing’s success in making the renminbi the world’s fifth-most traded currency should be attributed to the renminbi’s strength.
Since 2008, Beijing had to allow the renminbi to strengthen rapidly to encourage investors and businesses abroad to use the currency, since investors tend to hold currencies the value of which is on an upward trajectory.
Now that the renminbi’s value will likely head south as the US dollar continues to rise, international investors’ enthusiasm for holding renminbi assets may decrease, which will pose a real challenge to the currency’s internationalization.
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