Chinese currency devaluation: Q&A

Derry Pickford, Macro Analyst, Ashburton Investments.

Amid the shockwaves from the devaluation of the Chinese exchange rate, Ashburton Investments' Macro Analyst Derry Pickford answers some FAQ’s on the implications of this move by the People’s Bank of China. Follow us @AshburtonInvest.

What has happened to the Chinese exchange rate?

On the morning of Tuesday 11 August the People’s Bank of China (PBC) devalued the USDCNY Fix – the official rate for the renminbi (also referred to as the yuan or CNY) - by 1.86% to 6.2298. The market exchange rate depreciated by a similar percentage to 6.325. This morning the PBC depreciated the Fix again to 6.3306 with spot rates then falling to 6.4489 intra-day before late intervention led a recovery at the close towards 6.3858. The fact that the PBC forced a recovery towards the end of the day suggests that they would like to see some two-way volatility in the exchange rate.

Sources: Bloomberg, Ashburton, PBC

A 2.83% depreciation over 2 days doesn’t sound very much – the rand has depreciated more than that over two days and 18 times in the last five years!

The size of this move is not very important in itself and it is unlikely to do much for either net exports or Chinese deflationary pressures. More important than the move in the Fix was the announcement that the spot rate would determine the Fix for the next day:

"quotes of central parity that market makers report to the CFETS daily before market opens should refer to the closing rate of the inter-bank foreign exchange market on the previous day, in conjunction with demand and supply condition in the foreign exchange market and exchange rate movement of the major currencies"

Sources: People’s Bank of China (translation Credit Suisse)

This would suggest a move towards a dirty float. According to the BIS (Bank of International Settlement) calculations, the CNY on a broad trade weighted basis has appreciated by over 50% since its appreciation back in July 2005. Although the CNY was cheap then, there is concern now that the CNY may have overshot fair value. A small adjustment does nothing to change the perceived extent of how over or undervalued the currency is, but will lead people to assume that an adjustment process is underway. There is a strong chance that this is the start of a significant CNY depreciation trend. Such a scenario would create a huge headwind for emerging market currencies and commodity prices. It also risks encouraging an acceleration of capital outflows out of the country (see below).

However, if the CNY did start depreciating significantly, there is also the chance that the US Treasury could declare China a currency manipulator. US Senator Sherrod Brown, sponsor of the Currency Undervaluation Investigation Bill, immediately railed against China stopping “at nothing to give its exports an unfair advantage”. Presidential candidates have also been putting their oar in. For this reason we think that China will probably wish to avoid a large depreciation if it can.

Could this prevent the Fed from tightening rates?

Whether the Fed tightens on 17 September or not will be predominantly decided on domestic factors, not least the strength of labour market indicators. On domestic factors alone we think it is a 50-50 call whether they will go ahead or not.

By making the cost of imports cheaper, depreciation of the CNY/appreciation of the USD has a deflationary impact on US prices. USD strength over 2014 and early 2015 probably pushed back the start date of Fed tightening. The move so far in USDCNY is not by itself sufficiently large to have any noticeable impact on US inflation. Only if the Chinese devaluation was to continue or turn disorderly in the next few weeks is it likely therefore to override the domestic data. As we only have this as a risk case rather than a base case, and we also believe that the US labour market will continue to strengthen, we still believe that the Fed will still start the process of increasing interest rates this year.

Why did the PBC do this now?

There are many potential answers being put forward some of which many have an element of truth in them, but none probably provides the whole picture.

One suggestion is that this is a response to the International Monetary Fund’s (IMF) reticence about including the CNY in the SDR (Special Drawing Rights - the unit of account at the IMF). The IMF wanted greater market determination of the exchange rate before the CNY is included. The perceived wisdom prior to the move on Tuesday 11 August was that by keeping the currency stable against the USD the CNY would be seen as a good store of value. This would encourage the use of the CNY as a reserve currency, with the ultimate aim of internationalising the RMB so that it could become a competitor to the USD in financial markets. Perhaps with SDR inclusion a more distant prospect, the Chinese authorities have decided that the attractiveness of keeping the CNY stable is therefore minimal. At the same time this move sent a reminder to the IMF that the USDCNY peg has been a useful source of stability for emerging markets. The IMF welcomed the move stating:

“The new mechanism for determining the central parity of the Renminbi announced by the PBC appears a welcome step as it should allow market forces to have a greater role in determining the exchange rate. The exact impact will depend on how the new mechanism is implemented in practice.”

Another explanation is that the Chinese authorities desperately want to stimulate the Chinese economy in the face of rapidly slowing growth. Exports in July were unexpectedly weak, contracting in value terms 8.9% year-on-year. The July Caixin PMI – a survey of conditions in China’s manufacturing sector - came in at 47.8 when the flash estimate a few weeks earlier had been at 48.2, suggesting a deterioration of conditions towards the end of the month. July industrial production data also disappointed with growth falling to 6% year-on-year, from 6.8% in June.

Won’t this depreciation encourage capital outflows from China?

By moving in incremental steps, the PBC could create an expectation of further depreciation. This will encourage an acceleration of capital outflows. It was probably no coincidence that the PBC in a statement on Tuesday’s move noted that:

“The PBC and SAFE will severely punish illegal FX transactions, including underground banks, and maintain a compliant and orderly capital flow.”

Source: People’s Bank of China.

In theory, China’s closed capital account means that the amount of outflows should be able to be controlled by State authorities. Of course, the reality is more complex. Chinese FX reserves have fallen by over $340 billion since June last year (nearly 9%) despite running a current account surplus of nearly $220 billion in the three quarters of published data since then. Some of the fall in FX reserves is a function of valuation losses (holdings in euros will have fallen in USD terms), as well as some transfers to policy banks. The balance on the financial account in Q1 fell to a deficit of $79 billion in Q1 of this year. This is not suggestive of a country which is in full control of its capital account. If they wish to maintain the value of the Renminbi they will need to have a crack-down on capital outflows.

Will capital outflows undermine domestic financial conditions?

“The impossible trinity”, also known as “the trilemma”, states that a country can’t simultaneously control the exchange rate and domestic monetary conditions, and still have free capital movement. If the capital account is closed, there shouldn’t be an issue with both having an independent monetary policy and fixing its exchange rate. If capital controls are leaky though then it makes it tricky to both maintain control over monetary policy and set the exchange rate.

The $3.6 trillion in FX reserves gives the Chinese authorities a degree of wiggle room and can be used to support the currency. When a central bank sells FX reserves this usually reduces domestic liquidity. However, there is some extra-wiggle room here too. There is around $900 billion worth of non-money liabilities on the right-hand side of the balance sheet that could be reduced before domestic monetary base is impacted, although in reality buying back these liabilities may be tricky. Alternatively the PBC could expand the domestic portion of the asset side of its balance sheet. This would leave more money in the hands of the private sector. If they believe the currency is depreciating, they will want to use it to buy USD.

Furthermore, China has a very high reserve requirement ratio (RRR). By slashing this, the monetary base growth could stall or even contract without this necessarily causing a slow-down in broader money supply growth. Nonetheless, the process may not be smooth. Slashing the RRR doesn’t automatically encourage banks to go out and lend and thereby create broad money. This is particularly true if a contraction in narrow money undermines bank confidence, and creates a desire to hoard liquidity. Rather than tackle the adverse effects of a contracting monetary base, it may be easier for the PBC to let the currency slide instead.