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Arthur Kroeber: China's yuan devaluation is not a currency war

China's currency move has nothing to do with cyclical economic management and everything to do with creating a more flexible exchange rate mechanism

Arthur Kroeber 

Currency War
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It looks, at long last, as if China is serious about having a largely market-driven exchange rate. After Tuesday's surprise move, which saw the People's Bank of China (PBOC) push the daily fixing of the renminbi against the US dollar down by -1.9 per cent and declare that future fixings would be determined by the previous day's closing spot rate, the central bank followed through today. Wednesday's fixing, at CNY6.33, closely matched the prior day's close, and was a -1.6 per cent depreciation from Tuesday's fixing. The market is driving the renminbi down, and the PBOC is letting it.

Ignore silly headlines about "currency wars". We hold firm to the view, that the currency move has nothing to do with cyclical economic management and everything to do with creating a more flexible exchange rate mechanism that will enable the renminbi's admission into the International Monetary Fund's (IMF) special drawing rights (SDR) basket. A more flexible exchange rate is also a necessary step to push ahead the market-oriented reform agenda outlined by President Xi Jinping nearly two years ago - an agenda that in recent months has seemed in danger of stalling.

In the medium to long term, it will be good for both China and the world for the renminbi to trade more freely. China accounts for 18 per cent of global manufacturing exports, vies with the US for leadership in outbound direct investment, and is an increasingly important source of portfolio capital. Under these conditions it is senseless for China to cling to a currency whose value is determined by government fiat. From a domestic point of view, the exchange rate is one of the very few remaining controlled prices in the world's second-largest economy. If the government is really serious about giving market forces "a decisive role" in resource allocation, as it pledged in its November 2013 reform road map, then the exchange rate has to be freed up.

In the short term, however, freeing the renminbi creates some problems, partly because of global circumstances and partly because of previous blunders by Beijing. The currency is being let off its leash right at the moment when market sentiment on China is pessimistic because of a continuing economic slowdown, an increase in private capital outflows, and entrenched producer price deflation. Market confidence was also shaken by the authorities' clumsy intervention to prop up the stock market after the popping of the equity bubble in June. In this context it is not surprising that many traders and analysts have interpreted the currency move - wrongly, in our view - as a last throw of the dice by a government panicking about an economy in free fall.

The move is also inconvenient for Janet Yellen's Federal Reserve, which has strongly signalled its intent to end its seven-year zero rate experiment with an interest rate hike in September. A falling renminbi adds to the deflationary pressure that has gripped the globe since last year's oil price collapse, and sharpens the Fed's dilemma. Based on the criteria it has set out - mainly the state of employment and wages - the US seems ready for a rate hike. The rest of the world, though, seems less so.

Finally, the politics of the renminbi's inclusion in the SDR have become trickier. The IMF was swift to welcome the PBOC's decision to free up the currency, signalling once again that it would like to see the unit in the SDR. But the egregious US Senator Charles Schumer, leader of the Congressional China-as-currency-manipulator claque, was equally quick to denounce the move as yet more evidence of Beijing's nefarious mercantilism - which according to him, should disqualify the currency from SDR inclusion. So far as we can tell the Obama administration would like to support SDR inclusion, but the farther the renminbi falls the more politically difficult this support becomes.

My suspicion is that in a few months' time all these anxieties will prove to have been overblown. First, the moves in the renminbi so far are significant in terms of the currency's own past history, but are pretty modest by the standards of currency markets in general - especially given that over the previous year the renminbi had appreciated in real effective terms by more than 10 per cent because it was chained to an ultra-strong dollar. The forward market has been pricing the renminbi at around CNY6.5 to the US dollar, which seems roughly fair value, and a devaluation much beyond that, to CNY6.6 or CNY6.7, is likely to draw buyers with a longer time horizon back into the market. Most likely the Fed sees all this, and will not use China as an excuse to delay its rates hike.

Second, by timing this move now the PBOC has done its best to ensure that the renminbi's gyrations will be finished by the time Xi goes to the US in September for his summit with Obama, and certainly by the time the IMF board meets in November. If the PBOC continues to follow through on its pledge to let the market have the main say in the daily fixing, it will quickly become much harder for the likes of Schumer to credibly argue that China's currency policy is a mercantilist conspiracy.

The key thing now is for the PBOC to establish its credibility as the steward of a market-driven exchange rate, and as the vanguard of China's much needed financial liberalisation. After the stock market rescue (in which the PBOC appears to have been a most unwilling participant), confidence in the trajectory of China's economic reforms has suffered severe damage. A show by the central bank that it is willing to let the market guide the exchange rate, and that it will stay this new course even if the short-term consequences are inconvenient for the politicians, would be a sign of maturity and strength. Good luck to it.

The author is founding partner and head of research, GaveKal Dragonomics

First Published: Thu, August 13 2015. 09:35 IST