By Alex He The past few weeks have been turbulent for China’s economy, to say the least, with its currency, the renminbi ...
By Alex He
The past few
weeks have been turbulent for China’s economy, to say the least, with its
currency, the renminbi (RMB) — also known as the yuan — declining sharply,
nearly two percent against the dollar on August 11, the biggest one-day change
in the currency in 20 years. In total, it experienced a 4.4 percent devaluation
from August 11 to August 13, shocking the global financial markets. The world
interpreted China's move as a currency war or currency manipulation, prompting
the devaluation of currencies in many emerging markets. US politicians, ranging
from the constant critic of China's currency policy, Democratic Senator Charles
Schumer, to a newcomer in the accusation, Republican presidential candidate
Donald Trump, joined the barrage to criticize the RMB's devaluation as a way to
gain a competitive advantage for China's exports.
China defined
the entire scenario in its own way. It rejected the criticism that the move was
either a currency manipulation or a currency war. The People’s Bank of China
(PBoC) explained its unexpected move was designed to alter the way it sets the
initial price (the midpoint price or the central parity) of the RMB against the
US dollar. As the PBoC promised, it was an icebreaking step toward a more
market-oriented approach to set the RMB’s value, to further promote RMB
exchange rate formation mechanisms to reflect supply and demand in the market.
Before the
adjustment of August 11, the RMB was under great pressure of falling in the
market over concerns of a slowdown in China’s economy and the expectation of a
stronger dollar. What the PBoC did on August 11 was to go with the tide, and
duly started a significant move on the market-oriented reform on an exchange
rate formation mechanism. The PBoC allowed the midpoint price for the RMB to
fall two percent, which positioned the central parity of the RMB against the US
dollar closer to the actual RMB prices in the market, and made it clear that
the PBoC wanted to follow the RMB value set by market forces. Ideally, the PBoC
hoped that in the near future, the initial price it set for the RMB would be
very close to the closing price the previous day. In that case, the PBoC would
no longer need to set the RMB midpoint price and the market would determine the
price of the yuan.
However, the
PBoC still maintains its great influence on the control of RMB exchange rate
for a good reason: the devaluation or appreciation of the yuan on a large scale
either way will impact China’s economy and the global economy in a negative
way. In the case of devaluation under current circumstances, it would surely
bring a large-scale depreciation and higher inflation, as well as add a greater
burden for Chinese companies whose debts are mainly denominated in US dollars.
It would also cause severe capital flights. For China, the key word “control”
must be maintained, with a managed fluctuation being a more appropriate policy
option.
The best move
the PBoC could take, perhaps, is to push toward a market-oriented currency, without
causing dramatic fluctuations. Therefore, measures had to be taken by the PBoC
to prevent the yuan from falling further. The PBoC jumped into the currency
market to push up the value of yuan when it seemed the RMB would decrease
substantially in the two days following the announcement on August 11. In the
following two weeks, the PBoC flooded the market with more liquidity to sustain
the RMB by declaring a dual cut on the interest rate and reserve requirement
ratio, as well as selling more than US$100 billion of reserve assets via open
market operations.
Another word,
“balance,” reflects why the recent RMB devaluation is controlled within an
affordable range by the Chinese government. On the one hand, the adjustment to
the yuan’s mid-price helps the PBoC to fulfill its goal to let the market play
a bigger role in deciding the price of the yuan and to let it fluctuate in both
directions. The move was welcomed by the International Monetary Fund (IMF) and
it improved the RMB’s standing at this important international financial body.
The allegations of currency manipulation by China, held by some American
politicians, were widely promoted to the US public and US Congress. In reality,
China’s policy on the RMB exchange rate is far more complicated than “currency
manipulation.” Since China began its exchange rate formation reform in 1994,
the PBoC has been setting an initial price for the RMB in dollars each morning,
and then allowing the currency to trade in a narrow band. The market-oriented
reforms on China’s RMB exchange rate formation mechanism have been promoted
since 2005. For years, the United States and the IMF have urged China to
liberalize its exchange rate and let the market play a more important role in
determining the value of its currency. The move by China on August 11 is a
significant step toward that goal.
On the other
hand, the PBoC is not the only voice in the currency policy-making process in
China. It needed to pacify domestic pressure from the export sector. Other
considerations on maintaining a stable export market also have a great impact
on the policy-making process. The yuan has been rising in strength as the US
dollar continues to appreciate over the last year, because it has been loosely,
but consistently, pegged with the dollar. The yuan also continues to appreciate
against others currencies over the past few years. Consequently, the yuan kept
rising against the currencies of China’s main trading competitors and partners,
which put China’s export sector in a very disadvantageous condition. That is
why China’s State Council had come to the conclusion at the end of July that
the currency had to be part of the solution to fix the export problem. The move
by the PBoC on August 11 is believed to have taken into account the voice from
the export sector and its supervisor, the Ministry of Commerce.
Nevertheless,
the surprise move for the two percent yuan devaluation still startled investors
around the world and set off huge negative shocks on global stock and
commodities markets. Together with the Chinese government’s clumsy, failed
intervention to prop up the stock market about a month prior to devaluation,
the devaluation was interpreted (mistakenly, some Chinese analysts insisted) by
investors around the globe as a sign that the fundamentals of the Chinese
economy may be in worse shape than many had thought. As the Shanghai Composite
Index dropped 8.5 percent on August 24, the worst single-day loss in more than
eight years, followed by another 7.6 percent fall the next day, the worry and panic
in the Chinese market transmitted across the world and caused the global
financial markets to fall sharply on the same day out of worries about the
prospect of China’s economic development.
The negative
reaction in the global markets was not what the PBoC expected. China’s
explanation on why it had devalued its currency — i.e., to adjust the yuan’s
value to respond more closely to market forces — was taken by global investors
as “eyewash” to provide the “political cover for devaluation.” China’s currency
policy was introduced based on its leaders’ judgment on its economic
fundamentals and a calculation of the policy’s possible political consequences.
It is perhaps beyond China’s ability to adequately foresee the spillover effect
of its policy making on the global economy, when it introduced the policy in
the first place. As a further measure to stabilize confidence in China’s
economic growth, the PBoC announced on late August 25 an unusual policy
combination to cut the interest rate and banks’ reserve requirements
simultaneously, pumping out more liquidity into its bank system, with the
intention to counter the ongoing economic slowdown and the shocking stock
market selloff. It also declared it would liberalize some deposit rates and
give banks more leeway to set deposit rates with a term over one-year deposit,
but it would still maintain its control on the one-year benchmark deposit
rates.
The steps the
PBoC made toward a market-oriented exchange rate and interest rate will enable
China to pursue a more traditional monetary policy and maintain a healthy level
of economic growth. These measures indicate less direct management and control,
as well as more market tools for the PBoC to balance China's economy in coming
days. Still, there is a long way to go before China can totally give up the
crucial tool — the managed exchange rate — which China believes could keep the
effects of global economic turbulences at bay. Whether recent efforts at
market-oriented financial reform can bring back the confidence needed to stop
the current economic slowdown in China still remains to be seen.
This analytic article was first published at Center for International Governance Innovation, Canada on Aug 31, 2015
About The Author:
Xingqiang
(“Alex”) He is a CIGI Visiting Scholar. He is a research fellow and associate
professor at the Institute of American Studies at the Chinese Academy of Social Sciences (CASS).
He has
coauthored the book A History of China-U.S. Relations and published dozens of
academic papers and book chapters both in Chinese and English. He also
periodically writes reviews and commentaries for some of China's mainstream
magazines and newspapers on international affairs.
He has a Ph.D.
in international politics from the Graduate School of the Chinese Academy of
Social Sciences. Before beginning his Ph.D., he taught international relations
at Yuxi Teachers College in Yunnan Province, China.
