The depreciation of the Chinese currency has accelerated in an unprecedented pace after New Year’s Day.
Besides the influence of a strong US dollar, the renminbi’s weakening exchange rate may also be due to the change in its exchange rate mechanism.
Among the various reform moves taken by the Chinese central bank, the most important is that it announced a CFETS renminbi index which is based on a basket of currencies. The new strategy is to price the renminbi based on a basket of currencies instead of maintaining a de facto semi-peg to the dollar.
Since Dec. 11, the renminbi has devalued by 3 percent against the greenback, but only about 1 percent against its pricing basket.
The divergence in the monetary policies of global central banks has supported the dollar’s uptrend. Thus, unpegging from the dollar is a wise choice. It will benefit China’s export sectors and, as China gradually opens up the capital account, help keep the independence of its monetary policy. This leaves room for China to adopt a loose monetary stance.
But a sharp devaluation creates risks. Firstly, mainland companies with heavy dollar debts will suffer, especially when their yuan-denominated earnings decrease.
Our estimation shows China’s non-financial sector has US$400 billion to US$500 billion short-term dollar debts.
This is unlikely to trigger systemic risks in terms of international transactions but it is a big concern for individual companies.
Secondly, the devaluation will affect both overseas and domestic investors’ expectations because most of them made investment decisions based on the exchange rate of the renminbi against the dollar.
Capital outflow will increase. In December, China reported a decrease of US$107.9 billion in its foreign reserves. That’s quite significant.
Moreover, once expectation for further renminbi devaluation emerges, yuan-denominated assets like properties and stocks will be put under pressure.
The A-share market’s rout on Thursday is linked to the renminbi devaluation. And it’s not favorable for decision makers.
The moves taken by the People’s Bank of China are reasonable from the macroeconomic point of view.
But it should do better in communicating with the market so that the market’s expectations remain under control. Otherwise, risks will emerge.
This article appeared in the Hong Kong Economic Journal on Jan. 8.
Translation by Myssie You
[Chinese version 中文版]
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