The People’s Bank of China (PBoC) rocked global markets in August by suddenly changing the renminbi’s daily fixing mechanism, a move that led to a more than 3 percent depreciation of the yuan against the US dollar.
But the markets reacted for all the wrong reasons, in my view.
According to conventional wisdom, China’s move was a devaluation, under the guise of foreign exchange reform, to boost exports and, hence, economic growth.
This is unlikely. Firstly, China’s economic weakness may not be as dire as many observers think, even though industrial output, electricity consumption, freight volume and demand for raw materials have all grown slower than the 7.0 percent GDP growth rate.
If China’s growth situation was so dire, why did Beijing wait until now to make the FX policy shift, and why did it not devalue the renminbi by much more?
The fact is that China is making a transition to a new growth model, with the tertiary sector growing faster and now larger than the secondary sector.
Tertiary demand, such as for healthcare, education, tourism, entertainment and financial products, is not energy and industry intensive.
Hence, traditional macroeconomic output indicators, such as energy consumption, industrial output and freight volume, are giving a distorted picture of China’s growth.
More crucially, devaluation is not an effective tool for boosting Chinese exports and, hence, GDP growth. Empirical evidence shows that the predominant factor affecting Chinese export growth is global demand, not the exchange rate.
Further, the impact of global demand on Chinese export growth is 20 times bigger than the exchange rate impact.
In other words, China’s exports do not need a cheap renminbi. In fact, China’s exports have continued to gain global market share despite the steady rise in the renminbi’s trade-weighted exchange rate since the 1990s.
If devaluation were to give Chinese exports a competitive boost, our estimate shows that the renminbi would have to be devalued against the US dollar on a sustained basis by 20 percent to 40 percent, depending on the currency-weight assumptions one uses.
This would potentially create an unacceptable global financial shock.
Ultimately, it is the GDP growth impact of currency devaluation that counts. Evidence shows that China’s net exports have not been contributing to GDP growth since 2009. They have actually been a drag on growth.
Meanwhile, the costs of a large devaluation were likely to create a devaluation expectation spiral, generating destabilizing capital outflows from China and worsening the financial burden on Chinese firms that had borrowed unhedged in US dollar. (This debt, which includes borrowings in Hong Kong dollars, is estimated at US$480 billion or more than 4 percent of GDP as of the first half of this year). These risks could potentially become systemic.
In short, the expected benefits of devaluation are marginal and uncertain but the expected costs are substantial and imminent. Devaluation is not a worthwhile strategy.
Rather, the move to change the daily fixing mechanism is a step towards renminbi liberalization as China moves to open up its capital account.
But capital account liberalization is forcing China to pursue a major overhaul of its economic, financial and policy frameworks.
Beijing’s move to reform the fixing regime is another step to making that change. It also has a strategic goal of boosting the likelihood of the renminbi becoming a reserve currency by directly addressing the concerns of the International Monetary Fund about the renminbi’s inconvertibility.
Beijing is campaigning for adding the renminbi to the currency basket that forms the IMF Special Drawing Rights (SDR), which is a fast-track for the renminbi to become a reserve currency.
The ultimate importance of the SDR for China is that it is a signpost for China’s capital account liberalization and, hence, structural reform progress.
Assuming China follows through on its pledge to open the renminbi to market forces, it can credibly claim that its currency is “freely usable”, which is a condition for a currency to be included in the SDR basket.
And once the renminbi becomes an SDR component, Beijing can use that status as an external force to push for more structural changes, just as it did by using its membership in the World Trade Organization to force reform in the state sector in the early 2000s.
The IMF staff report in early August highlighted that a more market-based valuation of the renminbi rate against the US dollar would be needed as a key factor for considering the renminbi’s inclusion in the SDR basket.
This could well have been the trigger for Beijing’s decision to change the renminbi fixing regime on Aug. 11.
If the renminbi is to become a reserve currency, it must be priced in its own right rather than simply being a carbon copy of the US dollar.
Beijing’s reform of the renminbi fixing regime shows it believes it is time to sever the renminbi’s ties with the US dollar. Arguably, this is a statement of confidence rather than a sign of weakness.
Opinions here are of the author’s and do not necessarily reflect his employer’s.
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