China's Latest Currency Actions Are Market Driven

August 11, 2015 4:15 PM

China's central bank took a potentially major step toward a more market-determined exchange rate on August 11, when it announced a revision in the process for fixing the central parity exchange rate, the starting point for daily trading of the renminbi (RMB) in the onshore market.

While the reform has set off alarm bells in some quarters, it is unlikely that this move will usher in another chapter of currency manipulation to support Chinese exports and thus its economic growth. China may well be concerned about an economic slowdown accompanied by a slump in exports, but its motivation for this move is almost certainly tied to another objective: China's aspiration to have the RMB join the four other major international currencies (the dollar, the euro, the pound sterling, and the yen) that comprise the so-called special drawing rights (SDR) basket of the International Monetary Fund (IMF). The IMF executive board will decide in November whether to include the RMB in that basket.

In a special report issued last week, the IMF evaluated the suitability of including the RMB in the basket. One concern raised was deviations between the offshore (CNH) and the onshore (CNY) rates. Moving toward a more market-determined onshore market is designed in part to address this concern. We should also expect the central bank in the near future to further liberalize access by SDR users to the onshore foreign exchange market.

The action taken by China, far from being a step to manipulate its currency, is actually an effort to let the RMB fluctuate according to the dynamics of the exchange markets. For months the RMB has weakened almost daily from the central parity rate. Every time it does so, the next day the central bank almost invariably sets the new parity rate at a level almost unchanged from the previous day. And on many days the central bank has intervened in the market (selling dollars and purchasing RMB) to prevent the RMB from weakening beyond the 2 percent trading band. In short, up until now the central bank has been largely overriding the market. In its latest step, the bank has announced that, when setting the central parity rate, it will take into account the closing rate of the previous day, the supply and demand conditions in the foreign exchange market, as well as the exchange rate movements of major currencies. Thus the central fixing on August 11 was at a level reflecting a 200 basis point depreciation of the RMB from the previous day's close.

China's move is consistent with long-standing advice from the IMF and from the US Treasury, both of which have repeatedly called for China to adopt a more market-determined exchange rate policy. We should expect this to lead to greater volatility and two-way movement in the value of the RMB vis-a-vis the dollar.


Sheldon Ray

Well done, Nick. The voice of reason, as usual.

Christina Dinh

I concur with Sheldon Ray. Great piece!

Ian Stuart

I don't see how you can judge anything about the Chinese motivation. Simply put, the jury is still out, but previous behavior from Beijing certainly doesn't encourage optimism. Perhaps they have changed but we can only wait and see. Moreover, until existing draconian restrictions on market freedom in trade and capital flows are abolished it is not clear that you can talk about a freely determined exchange rat.

Chi Lo

Dear Mr. Lardy,
Do you think, by reforming the fixing regime, the PBoC has also shifted its FX policy towards targetting the renminbi's NEER/REER from tragetting the USD?

Robert Kahn

Does the SDR have an actual purpose? Akinari Horli, speaking at Fung Global Institute in June 2015,
thinks not. "SDR is an accounting unit that some international organizations use, but there is no practical
significance to it beyond that. There is no private market for SDR instruments, because as a means of
payment, SDR has no settlement mechanism in kind. In order to use SDR for settlement of commercial
transactions, you have to unbundle the SDR into four national currencies before settlement."
"Even as an investment currency, the SDR has no appeal to the private investor. For a small investor in a
local economy, your utility function depends on the home currency, or the inflation rate of your home
currency's yardstick. If you are a global investor, on the other hand, you can create your own currency
mix tailor made."
"The SDR is something that is artificial. I don't see any point; Charles Kindleberger referred to the SDR in
1985 as an Esperanto equivalent for language. I thought at the time the analogy was pithy and continue
to do so."

Chi Lo

Yes, we all agree that the SDR doesn't serve any real world purposes, as Mr. Kahn alluded to. But acheiving SDR status has speical meaning to Beijing, other than just a face issue (which is also important for the chinese).
SDR is a fast-track for the renminbi to achieve reserve currency status, which is in turn a signpost for chinese financial reforms progress. Opening the capital account, i.e. the advent of Impossible Trinity, is forcing china to pursue a major overhaul of its economic, financial and policy frameworks.
Achieving SDR status, which the PBoC's move to reform he fixing regime is trying to help achieve, is an external force for Beijing to leverage on to making the structural changes in perparation for the Impossible Trinity. It is also a move conducive to RMB internationalisation and economic restructuring over the medium-to long-term.
Chi Lo

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Nicholas R. Lardy Senior Research Staff

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