What’s behind China’s currency devaluation?

China’s central bank, the People’s Bank of China (PBoC) surprised market by announcing it would use a daily fixing rate method to devalue the Yuan (the Renminbi or RMB). This was an historic decision as it signals a possible shift in short-term economic and financial dynamics across the world economy.

It also suggests the Chinese government has begun to address policy inconsistencies, foretelling a new round of policy initiatives designed to restore the economic vitality of the world’s second largest economy.

"China’s trade competitiveness is unlikely to be regained via exchange rate devaluation"
Li-Gang Liu, Chief Economist, Greater China

There were three major factors prompting the change:

  1. A more flexible exchange rate system will allow further monetary easing without needing to maintain exchange rate stability, allowing the PBoC to regain policy independence.
  2. A strong RMB would worsen China’s deflation trend and erode export competitiveness.
  3. The reform will help strengthen the case for the IMF to accept the RMB into its currency basket.

The triggering factor however was China’s struggle with weak exports which have registered negative growth over the past year. In fact the only other time in the past 15 years where exports were weaker was during the global financial crisis. And the outlook is not optimistic given sluggish global trade.

The question that many people will be now asking is whether yesterday’s announcement is just another step in the process of internationalising the RMB or whether China is attempting to create a lower exchange rate to counter a slowing economy and the rising tide of European and Japanese exporters. Clearly both motives at work.

A more flexible exchange rate system will allow further monetary easing and prevent a strong RMB worsening China’s deflation trend and increasing unemployment. Secondly, as the IMF indicated in its initial FDI review, the previous daily fixing rate did not reflect market conditions.

Now that it includes the previous day’s market supply and demand conditions and the changes of key currencies, the RMB’s chance of being accepted in the Special Drawing Rights (SDR) currency basket by year end has improved considerably.

The biggest impact of the change will be on volatility and Asian currencies with the RMB potentially taking on more of an anchor role for regional currencies. Meanwhile, the advances of other Asian currencies will be eroded.

However, China’s large external corporate debt of $US1.6 trillion will serve to guard against a sharp devaluation of the RMB exchange.

Moreover, China’s trade competitiveness is unlikely to be regained via exchange rate devaluation and can only be regained though improvements in technology and sophistication.

A more volatile RMB exchange rate also means China’s onshore foreign currency hedging market is about to take-off, benefiting financial institutions, especially those foreign banks operating in China with product capacity and licenses to operate.

In addition, China’s interest rate liberalisation will require investors to hedge future interest rate uncertainties. Given the size of the Chinese market, foreign banks will definitely have the competitive advantage in this rapidly growing fee-based business.

In August, China’s top leadership congregates in a seaside resort called Beidaihe to avoid the hot summer in Beijing and discuss policy priorities for the remainder of this year and next. Yesterday’s currency changes send an important signal that China’s financial liberalisation and reform are unlikely to be slowed despite the equity market collapse at the end of June. As long as China can continue to engage in difficult structural reforms and financial liberalisation and opening, a debt-led economic hard-landing is unlikely to occur.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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