Amid signs that China’s economy has been slowing for some time now, the People’s Bank of China (PBoC) may be less willing to allow the renminbi to continue along the seemingly one-way appreciation path it had travelled until the beginning of this year.
What are Chinese policy makers trying to do?
On most measures renminbi has begun to look overvalued. From a Real Effective Exchange Rate perspective (REER – the weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for the effects of inflation), the currency looks vulnerable (see figure 1). Meanwhile, the renminbi’s strength has shrunk China’s current account surplus (fig. 2).
While some commentators seem to think recent volatility in the currency (see fig.3) is nothing more than a blip in this longer-term appreciation trend, there are sound reasons why Chinese policy makers may welcome further depreciation, at least in the near-term.
Certainly the PBoC exacerbated the renminbi’s decline during March by loosening their grip on what was previously a tightly managed currency, as part of ongoing efforts to liberalise China’s monetary system. The Bank has widened the band around the ‘peg’ they set for the trading of renminbi against the US dollar from 1% to 2%, allowing for potentially higher volatility. Since this means the renminbi’s value can fluctuate more against the dollar in either direction, there’s room for discussion on what the PBoC is aiming to achieve with this move.
Does China need a stronger or weaker currency?
Some have argued that policy makers hope to allow the currency to appreciate at a faster pace in order to boost consumer demand. The new government that came in last year has spoken of the need to move towards a domestic-demand driven economy – away from the big tail risks of the sort of investment-led growth which in recent years has seen corporate debt build up to levels where widespread defaults are now feared. However, in this environment, surely the target of economic policy must be stability? It doesn’t make much sense that any country would want their currency to be going up while growth is clearly slowing. I don’t see how Chinese policy makers could expect to just magically increase consumption, therefore I believe they must be thinking of exports and competitiveness.
This is an area where China has begun to seriously struggle. In the face of a massive credit bubble, there are indications manufacturing growth is slowing (see fig. 4) and as costs increase, multinational producers may be moving their factories elsewhere.
Last year, renminbi’s steady appreciation combined with modest carry saw a surge in ‘hot money’ inflows. The PBoC now appears to be attempting to shake off carry-trade speculators who have been betting on a one-way rise against the dollar, distorting trade flows and complicating efforts to manage the Chinese economy more sustainably. Indeed, it was probably largely the unwinding of these carry trades that contributed to the renminbi’s sudden decline in recent weeks.
The PBoC say the new trading rules are designed to allow ‘market forces’ (rather than speculators looking to make ‘free money’ off China’s currency) to drive the renminbi’s value – as widening the band and introducing two-way volatility should give a greater indication of how the market really values the currency. However, in the face of this slowing economic momentum, it’s easy to argue they have good reason to be biased towards a weaker currency to help Chinese exporters lower their prices.
Whatever the PBoC is hoping for, one outcome we can almost certainly expect is increased volatility, which could mean greater risk.