The value of the Chinese yuan dropped for the second day after Beijing’s shock decision to introduce a new market-oriented daily reference rate setting regime. The move has sent shockwaves across global currency and equity markets, including Australia.
The People’s Bank of China, the country’s central bank, set today’s yuan/dollar fixing at 6.3306, which is 1.62 per cent lower than the previous day’s rate. This follows yesterday’s dramatic decrease of 1.9 per cent, the biggest drop in more than two decades.
The biggest question for currency traders, Australian miners and policymakers around the world is: how long will this devaluation continue? To put it simply, are we seeing the start of a new currency war involving the world’s second largest economy and our most important trading partner?
Let’s take a step back and look at yesterday’s unexpected decision. Beijing didn’t actually devalue its currency; it changed the exchange rate setting mechanism, which resulted in the sharp drop in the value of yuan against the US dollar. The difference is a subtle but an important one.
China did something the international community had been asking the country to do for a long time: adopt a more market-oriented and flexible exchange rate. But the result is not one that we wanted. The devaluation of the yuan has come at a time when many countries are engaging in beggar-thy-neighbour currency wars. This is a case of ‘be careful of what you wish for’.
Beijing has described the move as allowing the exchange rate regime to be more market-oriented.
“Recently, the central parity of the renminbi has deviated from the market rate to a large extent and with a longer duration, which, to some extent, has undermined the market benchmark status and the authority of the central parity,” the central bank noted in its statement yesterday.
The government is mostly right in this regard. The Chinese currency has been under persistent downward pressure for months due to weak economic performance and expectations that the US Federal Reserve is getting closer to hiking interest rates. However, the daily reference rate has, until yesterday, held the line, not reflecting the market forces at play.
However, the central bank’s shock move has sparked a fresh round of speculation about the real aim of the Chinese government. Has China finally decided to join the global currency wars of competitive devaluation in order to boost exports? Will Beijing let its currency crumble to reboot its export sector? How should we interpret Beijing’s sudden change to its foreign exchange policy?
Let’s hear it straight from the horse’s mouth. The head of research at China’s central bank, Ma Jun, who was previously Deutsche Bank’s chief China economist, said the change was a “one-time correction” to bring the reference rate in line with prevailing market rate. Ma warned people against reading into this as the start of a downward depreciation of the yuan.
Capital Economics, a London-based consultancy, agrees with Beijing’s official explanation: “We think it make more sense to focus on the official explanation that this is a one-off adjustment to how the reference rate is set as part of an ongoing program of market reform.”
HSBC and ANZ, two big Western banks with strong Asian franchises, also see the move in the context of broader-market led financial reform. “We believe the change in the onshore USD-CNY is more about emphasizing FX reform and flexibility. We maintain that China’s authorities are not directly trying to devalue their currency, as this could do harm to its RMB internationalisation efforts and longer term goals. ”
So what is the outlook for the Chinese yuan in the foreseeable future? In the near future, there will be a lot of volatility in the market as people adjust to the new environment of a more flexible exchange rate regime. But don’t expect the value of yuan to drop more than 5 per cent this year, otherwise it could lead to accelerated capital outflows and destabiliae the market. After the stockmarket rout, this is doubtful whether Beijing wants to play with fire again.
Liang Hong, chief economist at China International Capital Corp, says the long term exchange rate will be determined by the relative performance of Chinese and the US economies. She believes China’s relative strong macroeconomic conditions and especially viewed against other emerging market economies support a relative stronger Chinese currency.
It’s still too early to make a call. In the coming days, the Chinese yuan will presumably come under increasing downward pressure, but many market analysts believe Beijing will not simply take its foot off the brakes and let the value of the yuan dive.
The China economist at UBS says: “We think it is unlikely that the Chinese government will let only market momentum drive the renminbi exchange rate from now on, as that can be quite destabilizing.”
How China sets its daily reference rate in the coming days will be very interesting and important. It is a bit premature to declare yesterday’s decision as the start of a fresh round of global currency wars.