The People’s Bank of China announced an abrupt reform on Aug. 11 of the daily fixing for the renminbi.
The move triggered a 2.7 percent depreciation of the Chinese currency against the US dollar, and further weakening of the redback is widely expected.
How the renminbi fares in the future will be closely watched by a large number of companies and investors.
We need to distinguish between the short-to-medium term and the long-term trend for the Chinese currency.
Over the short and medium term, interest rates have a determining impact on foreign exchange given that large-scale and frequent cross-border capital flows dominate global financial markets.
And there are different theories on that topic, including interest-rate parity, balance of global payments and the sticky-price monetary approach.
On the rate parity theory, China has a higher interest rate than the United States, and the forward exchange rate of the renminbi against the US dollar should fall back.
That means the redback will weaken against the US dollar.
However, that is not what we’ve seen since 2005, when Beijing kicked off its foreign exchange reform.
Over the last decade, the renminbi has appreciated more than 30 percent, although China’s interest rate was high above that in the US.
The two assumptions for the rate parity theory, full convertibility and free arbitrage in the forward exchange market, are not yet applicable to China.
The theory can’t explain the short and medium term trend of the redback.
The assumption of global excess liquidity in the sticky-price monetary approach does not work for China, either.
How about the balance of global payments?
The theory makes no assumptions about arbitrage in the forward market and global capital flows.
Interest rates affect exchange rates in both the current account and the capital account.
Any interest rate change will affect costs for companies, the current account and the global payments balance and eventually affect exchange rates.
An interest rate change affects capital flows, then the capital account and the overall global payment balance and eventually ripples into exchange rates.
China has already opened its current account, and the impact on the current account is fully reflected.
However, the capital account has yet to be fully liberalized, and short-term capital can’t flow freely.
But the direct capital inflow and outflow are basically open, and financial investment is partially open.
The impact on the capital account will take some time to become evident.
The balance of global payments can be used to explain the short- and medium-term trend of the Chinese currency.
And the relative change of interest rates in the US and China will be the leading factor affecting the exchange rate through the global payment balance.
As we know, while the US Federal Reserve did not raise interest rates in September, the US dollar is set to embark on a cycle of interest rate hikes.
By contrast, the Chinese currency is in the middle of its interest rate cycle.
The two cycles are not fully synchronized but have long periods of overlap.
We believe this year and next year will be the overlapping period of the two opposite cycles.
The Chinese currency may weaken further against the US dollar, according to the balance of global payments theory.
In fact, the depreciation of the renminbi mainly stems from expectations of US rate hikes and rate cuts in China over the years.
Meanwhile, the level of the Chinese currency depends on the stance of the Chinese central bank.
China has US$3.6 trillion in foreign exchange reserves as a backup for Beijing to use to exert control over the currency.
The redback may weaken in a controlled fashion this year and next.
And the renminbi may lose further 1 percent to 6.45 against the greenback by year-end if the Fed’s liftoff occurs in October or December.
If not, the renminbi may stabilize at 6.38.
Its weakness may continue in 2016-2017 given the two opposite cycles.
However, the renminbi may return to its long-term track when the two cycles conclude.
This article appeared in the Hong Kong Economic Journal on Sept. 29.
Translation by Julie Zhu
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