RMB depreciation signals further reforms, not fears

By YU YONGDING, XIAO LISHENG / 01-05-2017 / (Chinese Social Sciences Today)

No panic over RMB depreciation


Cartoon by Gou Ben; Poem by Long Yuan


It is not news at all,
That the RMB is in a fall.
The exchange rate regime is in place,
So the market determines its pace.
There is no need to panic over depreciation,
And we must counter it without trepidation.
It is vital to prevent capital flight,
And to reform we should hold tight.


The RMB recently fell by 3.3 percent to 6.89 RMB per USD in a short span of 30 working days, exceeding the total depreciation amount of the past 10 months. The RMB exchange rate has again become the focus of media and public attention.

This round of RMB depreciation has been attributed to the new mechanisms determining the RMB exchange rate. The mechanism considers two factors: the closing price and the basket of currencies. As the USD index is driving the basket of currencies to appreciate, the RMB needs to stabilize the basket of currencies through depreciation against the USD. This article probes into the effectiveness and sustainability of the new mechanism and whether the RMB can reach a floating exchange rate regime in the future.

Reasonable depreciation
The People’s Bank of China (PBOC) announced the reform mechanism for setting the RMB exchange rate and the pricing formula of central parity rate (see link) on Aug. 11, 2015 (Aug. 11 reform) and released details in February, 2016.

In the formula, the difference between yesterday’s closing price and central parity rate reflects the RMB’s devaluation or appreciation as well as its intensity, revealing the currency departments’ expectation of market clearance in order to dampen monetary pressure.

According to the bank, the factor of the theoretical central parity rate relates to the CFETS index, which includes three aspects: RMB exchange rate to USD, USD index and other currency indexes. Both the RMB exchange rate to USD and USD index can lead to a higher CFETS index. In order to sustain the CFETS index, the RMB exchange rate against the USD should drop when the USD index goes up and vice versa. The bank involves the basket of currencies when setting up the exchange rate, indicating that global factors are also considered.

The RMB exchange rate against the USD has kept falling since October and recently hit the bottom over the past eight years. The USD index has grown by 4.5 percent but the CFETS index is stable. In terms of China’s domestic circumstances, a variety of macroeconomic indexes have been improved despite the pressure of RMB depreciation in the foreign exchange market. Also, no strategies are effective enough to weaken the RMB. However, there are unexpected changes in the global context such as Brexit and Donald Trump’s win in the US general election. Trump has promised to increase infrastructure input and reduce tax, leading to higher possibility that the Federal Reserve will raise interest rates. At the same time, the USD index has exceeded 100.

In circumstances like this, the PBOC should depreciate RMB to USD to sustain the CFETS index. The drop of the theoretical RMB exchange rate to USD itself can exert enough force to drive down the RMB’s central parity rate to USD. China’s capital outflows, increased by the inevitable higher ROA and interest rates, will also drive down the RMB’s parity rate. It stands to reason that the RMB has quickened devaluation, according to the current method to calculate the central parity rate.

PBOC’s alternatives
At present, the PBOC has three alternatives to deal with the pressure of RMB depreciation. It can either quit the intervening exchange market so to release the pressure in one attempt, or it can pay close attention to the USD and gradually depreciate the RMB until the pressure goes away as supply-demand relations change. Also, it may manage to reduce the exchange rate gradually until eliminating the pressure.

Expectations of RMB depreciation will remain as the pressure persists. At the same time, the RMB will experience devaluation if the USD index goes up, even if there is no pressure of RMB depreciation in the domestic foreign exchange market, according to the current method to calculate the central parity rate. Therefore, the expectation of RMB depreciation won’t disappear if there is expectation of a higher USD index.

Persisting expectations of depreciation is destined to encourage capital outflows, prolonging the process of easing the pressure of depreciation. Relief of pressure parallels the emergence of new pressure, which will cost a greater amount of foreign exchange reserves. All parties agreed to eliminate the unreasonable expectation of RMB appreciation from 2005 to 2015 but the problem lingered, leading to imbalances of global payments and cross-border resource allocation. A great deal of hot money flowed to China and was used in activities for interest and currency arbitrage.

Appreciation of the RMB lasted at least one decade during which period China accumulated a $4 trillion foreign exchange reserve. China has lost $80 billion of this since the 2014 depreciation. At this speed, how much foreign exchange reserve will remain if the depreciation endures? In fact, a great part of it has turned into real estate in America, Canada, Britain and Australia, and profits of Chinese and foreign investors and speculators. The gradual RMB depreciation means refusing to increase costs of capital flight. It also can be understood as encouragement of capital flight.

Also, slow depreciation has blocked independence of PBOC’s monetary policies. This year, PBOC’s second quarterly report on monetary policies states that frequent cuts of reserve requirement ratios (RRR) will greatly increase liquidity and lower the exchange rate. More liquidity means higher depreciation expectation of domestic currency, driving more people to buy foreign exchange and engage in speculation. This has become a circle, according to the report.

The report indicates that concerns regarding depreciation plague independence of monetary policies despite the new mechanism for setting exchange rates. Rather than alleviate it, the recent and fast RMB depreciation has amplified the expectation of depreciation.

Capital controls
In order to save foreign exchange and keep independence of monetary policies, PBOC has strengthened capital controls while conducting gradual RMB depreciation. This is the right decision, but capital controls can be performed in various ways. For example, setting foreign-exchange quotas is a direct form while collecting Tobin tax is an indirect one. To reduce price distortions due to capital controls, more indirect methods should be adopted.

Stricter capital controls are necessary, but they have a lot of disadvantages as well. For example, cautious monetary policies have cracked down on speculators who sell foreign exchange for interest arbitrage through long-term forward contracts. However, the entire long-term market has become sluggish as the amount of contracts was much smaller than before the Aug.11 reform, adding to enterprises’ costs of hedging. RMB devaluation itself constitutes a significant method to curb capital outflows and flight. It also helps to alleviate the pressure of capital controls.

RMB depreciation is not as terrifying as people imagine. International documents show that substantial depreciation will mainly cause four problems including inflation, currency mismatch of bank statements of assets and liabilities, sovereign debt crises and enterprise debt crises if over 25 percent.Chinese companies lent a large scale of debt when there was an expectation of RMB appreciation. If the RMB is devalued, their debt may soar in terms of RMB. However, these companies are unlikely to suffer irreversible impacts because of substantial RMB depreciation as they have greatly cut their debt in the last year.

Most people currently believe that depreciation shatters confidence, which may uncontrollably weaken the RMB. This opinion is groundless. China is the biggest country in terms of a favorable balance of trade and foreign exchange reserve. Its economic growth greatly outperformed global annual growth and its returns from financial assets outnumber those of America. The currency of such a country has never experienced depreciation of 20 to 25 percent throughout the history of the world economy.

Chinese economic fundamentals have no foundation for substantial RMB depreciation. Ultimately, the exchange rate will be determined by economic fundamentals despite its temporary overshooting. And remember, China hasn’t yet used capital controls which are the most effective method. There is no need to be concerned too much about the short-term and volatile depreciation.

Consensus has been reached in academia that floating exchange rate should be the basis for liberalization of capital projects. Indeed, with capital controls, market forces technically are not decisive to exchange rates. However, this is a transition that China must undergo to allow market forces more say. Capital controls prevent RMB from substantial depreciation and ease pressure in managing capital, thus distortions of market price and resource allocation.

The new mechanism for setting the exchange rate effectively steers gradual RMB depreciation, but it holds back market clearance and floating exchange rate. At a cost, the mechanism used a large amount of foreign exchange reserve, hurt independence of monetary policies and amplified market distortion caused by capital controls.

In the near future, higher ROA of USD assets may increase USD index and capital outflows and flight may expend, which may pose greater depreciation pressure on RMB. Based on backup plans, the PBOC needs to continue the thread of the Aug. 11 reform and complete the reform of mechanism for setting exchange rate in China.

Yu Yongding is a CASS Member and Xiao Lisheng is from the Institute of World Economics and Politics at the Chinese Academy of Social Sciences(CASS).