­­­­In a fix

While not a scientific principle, Sod’s Law is a phenomenon most people can attest to. WiC got a taste of it this month. Just a few days after we’d published our seemingly comprehensive 48-page special edition on the Chinese currency – The A-Z of the RMB – events overtook us. Suddenly missing from our pages was the most dramatic renminbi news of the year.

We weren’t alone in our surprise. Practically no one expected Beijing to devalue the currency. The shock caused a major market reaction – after all, the yuan experienced the largest one-day fall against the US dollar for more than 20 years – and soon had analysts making predictions that China could have triggered a currency war.

But over the past week there has been fresh analysis of the central bank’s move. The media’s initial headlines had indicated that Beijing was carrying out a mercantilist strategy to boost its exports and support a flagging economy. That had spurred a panic, with analysts wondering if it signalled China’s slowdown was worse than previously thought, and that its leaders were running out of policy options.

However, when economists undertook a closer examination of what the central bank had actually done, they saw another motive might be at work: that governor Zhou Xiaochuan was taking yet another step to reform the renminbi and make its rate more market-driven.

So what steps were taken?

Almost everyone was caught out by the announcement that the People’s Bank of China (PBoC) had devalued the yuan in a “one-off depreciation”. Hardly anyone welcomed it: share markets fell and currencies slid across the region.

The first step was raising the fixing price of the yuan against the dollar on August 11, approximating to an almost 2% weakening of the Chinese currency. The next day, because of changes in policy that brought the daily fixing price closer to the market rate, the yuan declined by a similar amount.

By the end of last week it had dropped by about 3% against the greenback although it has held its ground in trading this week.

The PBoC, which allows the yuan daily leeway of 2% either side of a fixed opening rate, has described the move as an important shift towards giving the market a bigger role in valuing the currency. Previously it asked the major banks each morning for reports on bid and ask rates for the yuan, although how this information was used to determine the reference rate was never made fully clear. “In theory it is the marketmakers, not the central bank, that set the midpoint. In practice the PBoC gets the marketmakers to submit rates that will yield its preferred midpoint, irrespective of market sentiment,” The Economist magazine explained earlier this month.

But now the authorities are saying that the midpoint fix will be set on a daily basis at a level closer to the closing rate of the interbank foreign exchange market on the previous day. Admittedly they are giving themselves room for manoeuvre by stipulating that supply and demand conditions will be taken into consideration, as well as the movements of major currencies. But because the new fix is primarily anchored against the previous day’s closing rate, most analysts are interpreting the changes as a step towards a more market-driven process.

Why have the Chinese made this move?

One of the more favoured interpretations is that giving the market more of a say supports Beijing’s efforts to reform its financial system and hastens a future in which the yuan takes on a more credible role as a global currency.

In this context, the announcement may have been shaped by an upcoming decision on whether to include the yuan in a small group of reserve currencies that make up the basket of special drawing rights (SDR), or foreign exchange assets, that are maintained by the International Monetary Fund.

China wants to see its currency included in the basket in the hope that it will fuel the global spread of the renminbi, as well as prompt further financial reform in its home market.

But one of the key stipulations is that its exchange rate has to be more market-driven, something that last week’s changes may have been designed to acknowledge (the Fund greeted the change in the fixing mechanism as a “welcome step”).

The authors of the Fund’s latest review of the renminbi’s readinesss to be included in the basket have asked for more time to complete their assessment of the yuan’s availability outside China, and also recommended that the expiry date on the current SDR basket be extended from the end of this year until September 30 in 2016.

Perhaps significantly, the IMF also outlined that full convertibility is neither a necessary or sufficient condition for a currency to be deemed freely usable, but that global markets must have adequate access to currencies in the basket. That may give Beijing encouragement that the yuan has a decent chance of being incorporated into the next revision of the basket, which typically occurs on a five-yearly cycle.

Or is China back to its old tricks?

Many in Washington have long claimed that Beijing has exploited its currency policy to keep China’s exports cheaper. Yet all but the most determined critics have been silenced by the yuan’s 30% rise against the dollar over the last 10 years, culminating in the IMF’s acknowledgement in May that it was “no longer undervalued” against its peers (see WiC284).

Still, long-term opponents of the Chinese like Chuck Schumer, the Democrat senator for New York, were quick to claim vindication after the PBoC’s move last week, portraying it as a typical attempt to gain an unfair trade advantage.

“For years, China has rigged the rules and played games with its currency,” he warned. “Rather than changing their ways, the Chinese government seems to be doubling down.”

Others grabbed the chance for a bit of grandstanding, including Senator Lindsey Graham, a candidate in the race to become the Republican presidential candidate. He was scornful about the sudden depreciation, calling it a “provocative act” and “the latest in a long history of cheating”.

Even Jon Huntsman, a former American ambassador to China and one of the more measured voices on Sino-US relations, voiced criticism of the move. “When you have the devaluation of 2% right off the bat automatically, you’re going to have a higher cost burden on the exports from the United States to Asia,” Huntsman told CNN. “When you look at the immediate impact that it had on currencies you get a sense as to why people are very, very frustrated with China.”

Are such allegations fair?

They come at a time in which Chinese leaders are trying to respond to the weakest economic growth for a generation, with growing speculation that the economy may not meet its official 7% growth target for this year. The more recent data has provided little cheer, with an 8.9% fall in exports in July on a year earlier, and a 6.8% decline in industrial production on the same month a year ago. So the premise is that Beijing is turning back to exports in the hope of a short-term boost to the economy. But because the yuan has strengthened so significantly against the currencies of its major trading partners over the medium term, last week’s drop in value doesn’t look enough to provide much fillip to most Chinese exporters, especially as currencies like the Korean won, the Australian dollar and the Canadian dollar fell sharply against the dollar too, effectively maintaining similar levels against the renminbi.

Others argue that China’s exports have been weaker because of lower demand for them in global markets, rather than a significant loss of cost competitiveness at home. So driving down the value of the currency is unlikely to yield much benefit, especially if any further devaluations trigger a competitive response from other Asian producers.

Paul Mackel, Head of Asian FX Research at HSBC, has written something similar. He reckons too that the central government still has other levers for stimulating the domestic economy, primarily by cutting interest rates or lowering the reserve requirements at the banks.

Instead Mackel sees the changes in exchange rate policy as part of a reform agenda that points to a “very market-determined approach”. In a research report last week he claimed: “We maintain that China’s authorities are not directly trying to devalue their currency, as this could do harm to its renminbi internationalisation efforts and longer-term goals.”

That interpretation might change if the central bank engineers a series of further falls in the yuan. But senior figures are insisting that this isn’t going to happen. Zhang Xiaohui, a deputy governor, reassured reporters last week that there was “no basis for persistent and substantial devaluation” and that the yuan was close to “market levels” after last week’s declines. Ma Jun, chief economist at the central bank, also reiterated that the government h­­ad “no intention or need to participate in a currency war”.

So why make the move?

Previously policymakers have supported the renminbi’s rise to encourage other countries to hold more yuan and to use it more in international trade. This was part of the broader effort to make it a worthier challenger to the dollar and the euro as an international currency. Thus may even have led the central bank to set the midpoint rate higher than market conditions may have sometimes implied.

This sense that the renminbi’s onshore exchange rate may have been more overvalued than undervalued was supported by the forward rates in the offshore market. Perhaps it contributed to the surge of capital leaving the country as well (HSBC now estimates that there has been at least $450 billion of net outflows since the second quarter of 2014).

For China’s policymakers the mismatch with the dollar also looked set to worsen as Washington prepared to hike interest rates. A stronger greenback was poised to make it harder to continue the policy of anchoring the yuan against the dollar, with volatility looking set to increase.

However, the sense that the central bank was acting to boost a struggling economy, was contradicted by its subsequent actions. That’s because the PBoC stepped back in to defend the currency the day after the devaluation by ordering the state-owned banks to sell dollars and buy yuan. Simply put, the authorities were looking to prop up the exchange rate at the same time they were being accused of trying to devalue it.

Although that may well undermine some of the emphasis on the market-driven motivations of the new policy, it also throws a different light on talk that the Chinese have just fired the opening salvo in a dangerous new ‘currency war’.

But if we started by talking about Sod’s Law, it might be worth ending with the Law of Unintended Consequences. If the central bank’s true goal was reform, the end result elsewhere has been to spark depreciations. This led the Financial Times to run the headline today: “China’s devaluation triggers dramatic falls in emerging market currencies.” The FT lists Vietnam, Kazakhstan, South Africa and Turkey as examples. And at this point it’s hard to say whether this is the start of a wider chain reaction that could destabilise sentiment.

To read our A-Z of the RMB, go to: www.weekinchina.com/books

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