How China can resist devaluation pressure

For China's economy, the most appropriate exchange rate regime is a free floating one

In July 2005, the People’s Bank of China announced it was implementing a managed floating exchange rate system based on market principles and with reference to a basket of currencies.

Between end-June 2005 and end-July 2015, the renminbi’s (RMB’s) exchange rate against the dollar rose to 6.12 from the previous 8.28, appreciating by about 26 per cent. The RMB’s nominal effective exchange rate (NEER) and real effective exchange rate (REER) indices appreciated by 48 per cent and 57 per cent respectively over the same period.

That the appreciation of the REER of the RMB exceeded its NEER indicates that the inflation level in China during this period was higher than the global average.

Between 2008 and 2014, the effective exchange rate for the RMB appreciated steeply, although the RMB’s exchange rate against the dollar remained stable. Therefore, the rapid appreciation of the RMB effective exchange rate was mainly due to the rapid appreciation of the dollar against other currencies. 
 

However, while the strong appreciation of the RMB’s effective exchange rate in 2008 was supported by the fundamentals of China’s economy, a similar appreciation in 2014 was a distinct deviation, given the subsequent decline in China’s economic fundamentals. This is why since the second quarter of 2014, depreciation expectations have taken hold, with the RMB’s appreciation against the dollar in the market expected to be reversed.

In August 2015, the People’s Bank of China again announced reforms in the RMB exchange rate regime, with the reform focus this time on the daily opening price of the RMB against the dollar in the foreign exchange market. 

Before the exchange reform in August 2015, the central bank prevented excessive appreciation (or depreciation) of RMB against the dollar on a regular basis by artificially lowering (or raising) the daily opening rate of the RMB against the dollar. In order to promote the RMB’s entry into IMF’s SDR currency basket however, the essential aspect of the 2015 exchange reform was that the central bank would voluntarily give up its intervention in the daily opening rate of the RMB against the dollar.

At the beginning of this reform process, the daily opening price of the RMB against the dollar was set at the RMB’s closing price against the dollar for the previous day. However, as the RMB faced significant devaluation pressure in the markets at the time, the decision of the central bank to abandon intervention in the opening price resulted in significant depreciation of the RMB against the dollar exchange rate. Between end-July 2015 and end-March 2017, the RMB weakened against the dollar, with the exchange rate falling from 6.12 to 6.89, devaluing the RMB by 13 per cent. During the same period, the RMB’s effective exchange rate also depreciated remarkably.

As the Chinese government has gradually liberalised the capital account, the depreciation outlook for the RMB is now expected to reverse. China’s previous net inflow of private capital has turned into an outflow; China had a sustained capital account deficit from the second quarter of 2014 to the fourth quarter of 2016, with the net outflow of private capital reaching $984.8 billion during this period.

To avoid the potential risks of the RMB’s rapid devaluation against the dollar, the central bank has adopted three new approaches since the RMB exchange rate reforms of August 2015. 

First, the central bank has frequently bought RMB and sold dollars in the foreign exchange market to stabilise the RMB exchange rate. As a result, China’s foreign exchange reserves have contracted, falling from a peak of about $4 trillion in late 2014 to about $3 trillion at present, down by about 25 per cent.
 

Second, China’s central bank now fixes the RMB’s daily opening price against the dollar taking into account two factors with respect to the daily opening price of the RMB against the dollar. In addition to the RMB’s closing price against the dollar the previous day, it also maintains RMB’s effective exchange rate against 24 other foreign currencies based on a 15-hour reference period before the opening of the working day. Both factors have equal weightage.

Third, China’s central bank has significantly strengthened the regulation of capital outflows.

For a large open economy such as China’s, the most appropriate exchange rate regime is a free floating one. China’s central bank should further strengthen the flexibility of the RMB exchange system, so that the exchange rate is determined by market supply and demand to a greater extent. This means that the People’s Bank of China should reduce or even abolish intervention in the foreign exchange market.

It may result in a significant devaluation of the RMB against the dollar in the short term, but it would also avoid excessive consumption in the foreign exchange market and strengthen the independence of the central bank’s monetary policy. Weighing all the pros and cons, this may be the more sensible choice for China’s central bank. 

The writer is Director in the international investment research office of the Institute of World Economy and Politics, Chinese Academy of Social Sciences, Beijing. This article is part of a series by Chinese economists facilitated by the Institute of Chinese Studies, Delhi