Many China economists and analysts knew the renminbi had been strengthening far too much in tandem with the dollar for the good of the fragile Chinese economy, but the People’s Bank of China announcement on Tuesday of a “one-off” devaluation of the RMB clearly caught the markets by surprise.
It has left many grappling to understand the true intentions of the Chinese currency regime change, whether it is truly as officially stated a start to a reform of its currency regime towards a more market-determined system, in part to gain the long coveted IMF reserve currency status, or a deliberate attempt to manipulate the RMB downwards in response to deteriorating domestic economic data.
The short answer is both.
*** Beijing will allow the markets under a reformed daily central parity fixing system to guide the RMB within its plus or minus 2% daily trading band, with full knowledge that the near term pressures will be to weaken the currency. But the pace of that adjustment will nevertheless be managed with periodic bouts of heavy intervention if necessary. Indeed, if the weakness in the RMB continues tomorrow, with the markets testing the 6.5000 level, the Chinese central bank may intervene to manage tomorrow’s central parity rate closer to 6.4500. ***
*** That begs the broader question of how far Premier Li Keqiang and President Xi Jinping, the real drivers of China’s currency policy, with the blessing of former premier Zhu Rongji, will allow PBOC governor Zhou Xiaochuan to take this process, and their ultimate goal and tolerance for a weaker RMB. We expect the currency depreciation to be managed closely, and take Beijing at its word that it will probably not lead to a drastic devaluation when the dust settles. We believe the volatility and sharp sell-off in the RMB will most likely dissipate after at most an around 5-7% move – of which we have seen almost 4% already. ***
*** Chinese officials will nevertheless also maintain that the situation today is not the same as during the 1997 Asian Financial Crisis, and the China of today has no duty to continue force RMB appreciation given its own domestic situation. Li and the central government will nevertheless not allow a currency freefall, and are acutely aware a sharp depreciation of the RMB could trigger capital flight, add volatility to the financial system, and crush foreign investor confidence. Furthermore, on a fundamental basis, Beijing expects second half growth to stabilize and recover from the first half, with August data reinforcing expectations of a stabilization in GDP of slightly above 7%, in turn stabilizing the currency. ***
*** Finally, the Chinese leadership has from what we understand also discussed other options to stimulate the economy if needed at their last meeting on August 8 at the Beidaihe resort, as well as considered other objectives for FX reform. At some point later this year, if the currency is not too volatile, Beijing may consider widening the daily FX trading limit to 3% in addition to the reforms just announced. And on the monetary stimulus front, perhaps not surprisingly, measures under consideration will include another potential cut in the RRR reserve requirement ratio. ***
Three FX Reform Options Weighed
Before Tuesday’s decision, the PBoC had been setting a daily central parity closing rate that consistently leaned against currency weakness in the market, fixing the level at the lower (stronger RMB) bound of the onshore interbank currency market, and miles away from the even weaker, unregulated offshore RMB market.
Going forward the PBoC will set the daily closing rate at the onshore RMB interbank closing market levels, in effect “condoning” that level for the next day’s open.
While China’s leadership is well aware that this reform would and most certainly will continue to lead to a weakening RMB, that does not mean the pace of depreciation will not be managed aggressively. If the markets do not settle by themselves, the PBoC is authorized and will intervene on the close to “adjust” that market driven rate to more reasonable levels.
Indeed from what we understand the PBoC presented three options to Premier Li Keqiang on the first day under the new regime for setting the closing central parity rate. Despite the sharp drop in the RMB that day, Li picked 6.3306, the highest of the three, in order to reinforce the stated objective of allowing the closing rate to reflect the interbank foreign exchange market as closely as possible.
On the second day of the new regime, faced with another volatile and sharply dropping market, the PBoC intervened heavily at the 6.4500 level, driving the RMB back to the more reasonable 6.3870 close, at which the central parity rate was set.
Global Central Banks Informed
The decision to begin the currency reform with the devaluation on Tuesday was not unrelated to concerns and expectations the US Federal Reserve may be hiking rates in the near future , putting even more upward pressure on the dollar and on the RMB in the process against other global currencies. In effect, if the RMB is to appreciate in tandem with a stronger dollar, Beijing wants the RMB to be rising from a lower level.
We also understand the PBoC may have, as a courtesy, given a heads-up to the Fed, the ECB, BoE, the IMF, and the heads of the BRIC central banks. While the Fed itself has not officially commented on the move, we believe there is little opposition if not even a good deal of support among the global central banks to a freer floating RMB that will most certainly result in a weaker currency given China’s growth outlook, even if there are some nagging concerns over exported deflationary pressures.
The reaction from the US Congress will be a different story, and by and large, as usual, ignored.