China’s currency devaluation increases certainty

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China’s surprise currency devaluation sparked a debate on whether it was part of the country’s ongoing financial reform or a measure to boost flagging exports. The plot thickens, as the flexibility now given to the currency is, ironically, forcing the authorities to step up their intervention, at least for now. It will take some time for the market to settle down and the currency’s direction to become clearer.

Regime Shift…

China’s abrupt devaluation of its currency, the renminbi (RMB), took the world by surprise and blurred the global economic outlook. The devaluation, of about 4.5% over a three-day period, sparked a debate on whether it was aimed at promoting reform—as portrayed by Beijing—or at boosting exports to shore up China’s struggling economy—a move that could set off a currency war.

We think it may be a bit of both, but the situation was still evolving at the time of this writing. China has managed to put a positive spin on the controversial move by placing it in the context of a reform to improve the currency’s flexibility, which the International Monetary Fund (IMF) has been asking for. But we’ll need to monitor developments further to determine where the RMB is headed.

…or Same Old Game?

The change in the currency regime was quite technical, and made the subsequent devaluation inevitable. Before, the Chinese monetary authorities had controlled the onshore fixing rate, which served as a powerful anchor for the spot rate (CNY). The incredible stability of the fixing since May underpinned the CNY/USD spot rate, although the spot rate was consistently trading about 1.5%–2% below the fixing.

On August 11, the People’s Bank of China (PBOC) lowered the fixing rate by about 2% to move it closer to the prevailing spot level, arguing that this one-off realignment was necessary to regain a policy equilibrium. Equally important, the PBOC abandoned its control of the fixing rate and made it flexible—a condition required by the IMF in order for the RMB to be included in the IMF’s special drawing rights (SDR) basket. Instead of being unilaterally decided by the PBOC, the daily fixing rate will now be referenced to the previous day’s closing spot rate, while also taking into account the supply and demand conditions in the foreign exchange market and China’s economic conditions. This way, the RMB exchange rate will, arguably, become more flexible and market-driven.

More Interventions or Fewer?

The PBOC followed through on its initial move with two more rounds of lower fixing rates during the week, as the spot CNY/USD also depreciated (Displays 1 and 2). At the same time, however, the central bank was also seen to have intervened quite heavily in the spot market to smooth the depreciation, as the declines in the spot rate and the fixing were starting to feed on one another. Central bank officials provided verbal intervention by saying that intervention will be needed if the market becomes disorderly. They stressed that the change in the currency regime was part of an exchange-rate reform, and that they had no intention of triggering a currency war.

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While the outlook for the RMB remains highly uncertain, one thing is sure. By abandoning its control over the fixing rate, the PBOC will have to resort to traditional foreign exchange intervention in the spot market. For now, that means selling the USD in order to stem the CNY’s decline. Experience in the global market tells us that a central bank’s solo foreign exchange intervention—as opposed to a globally coordinated intervention—tends to merely slow or smooth the trend of a currency, rather than change its course. But it’s fair to question whether China might be an exception to this. It possesses an extraordinary amount of ammunition—with US$3.6 trillion in foreign exchange reserves—to stop the RMB’s depreciation if it so desires.

The Right Balance

While we don’t doubt that China’s reserve assets could be an important stabilizing factor, the irony is that, if the PBOC’s intervention becomes too extreme, the flexibility of the RMB would be in question again, even though the central bank has given up its control over the fixing rate.

Also, by selling the USD and buying the RMB to counter the depreciation, the central bank would in effect be draining liquidity from the Chinese banking system. This will dilute the PBOC’s monetary easing efforts and may require more liquidity injections to neutralize the unintended sterilization effect.

It has been an incredibly eventful week in China’s foreign exchange market. The abrupt regime shift has brought more uncertainty than clarity to the outlook on the policy direction for the RMB. It may take a little more time for the market to judge what China’s policy objective might be, and its ability to keep the market in order.

 

By Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB

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