Along with the release of a CFETS renminbi foreign exchange index, the People’s Bank of China disclosed the weights of foreign currencies in its basket last weekend.
It’s a significant change and considered as a Christmas gift of PBoC to the market. The trend of renminbi exchange rate can be determined better now and traders and investors can plan their moves more efficiently.
After the exchange rate reform in 2005, the renminbi was priced based on “a currency basket” that included the US dollar, euro, yen and Hong Kong dollar. However, the weights of respective currencies had never been disclosed. The market’s guess had been that there was about 40-50 percent weight on the dollar, 20-30 percent on euro and 10 percent on yen, among other currencies.
Those who are familiar with the forex market would know that most of the trade settlements are denominated in the greenback. Currencies are quoted in the rate against the dollar on the market.
So, theoretically, the trend of currencies can be calculated by the change in the dollar index, except currencies pegged to the dollar, or not freely exchangeable, for example, the Hong Kong dollar and renminbi, respectively. Other currencies will fall when the greenback becomes stronger, vice versa.
There’s another currency mechanism, the managed float system. Singapore dollar and renminbi are the examples. These currencies will normally be linked to a currency basket and one has to make a voluntary decision on disclosing the weights of the basket components or otherwise.
Suppose the PBoC hasn’t disclosed the currency components’ weights in the basket, and we estimate based on the assumption that the dollar is weighted more than 40 percent, a strong dollar should have neutral influence on the renminbi exchange rate. Since 2010, the renminbi’s rate against the dollar has increased 5.6 percent amid a 26.5 percent increase in the dollar index.
However, on the other side, renminbi exchange rates against any of the foreign currencies should have smaller changes than the market. But the reality is, since 2010, yuan against euro rose 38.2 percent, yuan against yen surged 38.1 percent.
After PBoC released the weights, the market found that the dollar only accounts for 26.4 percent, about 20 percent lower than estimation, while the yen accounts for 14.6 percent and the euro accounts for 21.39 percent. Hong Kong dollar, which is pegged to the US dollar, has 6.55 percent weight. So the real dollar weight in renminbi pricing basket is about one-third.
Some observers have opined that the PBoC’s move indicates that the central bank will allow the renminbi to have bigger room for downward movement. I think the correct understanding should be that the renminbi is trying to move from a neutral position against the dollar to the opposite side.
In the future, stronger dollar will lead to weaker yuan.
This article appeared in the Hong Kong Economic Journal on Dec. 17.
Translation by Myssie You
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