The RMB Announcement: A Stimulating Reform
Q1: What policy steps did China take yesterday?
A1: On Tuesday morning China's central bank announced a two-part adjustment in its exchange rate policy. First, it stated although the central bank would continue to keep the daily maximum trading band for the Renminbi (RMB) at two percent in either direction, going forward the initial rate each day would be set in a more market-friendly manner. Instead of the central bank making the decision unilaterally in reference to the previous day's opening rate, the central bank would consult with "the market" (most likely a small group of banks) when setting the initial rate in reference to the previous day's closing rate. Consistent with that approach, the central bank on Tuesday morning announced a new reference rate for the Renminbi that was 1.9 percent lower than where it closed on Monday, from 6.1162 to the U.S. dollar to 6.2298 to the U.S. dollar.
Although the People’s Bank of China (PBOC) has not moved from a managed peg to a free-float, it is signaling that the long-term peg to the U.S. dollar is no longer sacrosanct and that the central bank will accept a degree of volatility never permitted before. In the short-term, given the flagging economy, the likelihood is for this liberalization step to lead to a modest depreciation. In forex markets in Asia outside China on Tuesday the RMB's value fell even further than the two percent band, suggesting a further fall in its value when the market opens in China and elsewhere on Wednesday, and potentially beyond then.
Q2: Did China's leadership do this to promote sagging exports or push forward economic reform?
A2: The leadership hopes to kill at least two birds with this stone. It is likely motivated by both short-term and long-term goals. In the short term, they are responding to declining exports, which is partly the product of the RMB's effective appreciation over time as the U.S. dollar has strengthened against a wide swath of currencies. In addition, depreciation may generate desired capital inflows in a period when there appears to have been capital outflows as a result of the country's economic troubles as well as the ongoing stock market volatility. But the policy adjustment is also aimed at liberalizing the exchange rate mechanism, which is necessary to achieve greater international usage of the RMB and is necessary as part of China's effort to have the RMB included in the International Monetary Fund's special drawing rights (SDR) basket of currencies.
It is unlikely that this policy adjustment will lead to a huge boost in China's exports on its own because Chinese goods are already priced competitively, and much of China's exports are made from imported components, and this depreciation makes those components more expensive. In addition, foreign demand is likely to be relatively limited because global demand is not growing quickly. However, this may at least give a psychological boost to Chinese exporters, which may raise Xi Jinping's domestic popularity.
Q3: Why does it appear that overseas markets, including in the United States, reacted negatively?
A3: There is likely concern of a substantial capital flow toward the RMB and China, which would mean less demand, for example, for U.S. stocks and bonds, which may explain part of the falloff in U.S. markets on Tuesday. There may also be concern that other countries could follow China, resulting in competitive devaluations. My view is that while we see short-term capital movements as a result of this step, these concerns are likely overstated in the grand scheme of things given the size of U.S. capital markets.
Q4: Does this signal that broader economic reforms are back on track after government intervention in the stock market?
A4: We will have to wait and see. If the RMB moves in either direction that generates either too much currency inflows (hot money) or outflows (capital flight), the key question is whether the central bank will resist the urge to intervene. If it can maintain self-discipline, this is a potentially positive sign for other reforms, including greater liberalization of the capital account and market access in sectors currently dominated by state-owned enterprises (SOEs). But if they re-intervene in a ham-fisted way, akin to what has been done in the stock market, then we will know that this was primarily about short-term stimulus and growth, and that the commitment to broader reform has waned. In that regard, this modest move has potential big implications.
Scott Kennedy is deputy director of the Freeman Chair in China Studies and director of the Project on Chinese Business and Political Economy at the Center for Strategic and International Studies (CSIS) in Washington, D.C.
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