Monetary Policy

The renminbi depreciation – a small step towards liberalisation

The heavy depreciation of the Chinese currency this week led to a worldwide shock through currency and stock markets. China’s spot renminbi fell nearly 2 percent in early trading on Tuesday, heading for its biggest daily drop ever. As if that was not enough, China further pushed down its official guidance rate by 1.6 percent on Wednesday, marking a four-year low, and almost to 1.1 percent on Thursday. The market-wide shock spilt over to stock exchanges. Within hours the German stock index (the DAX) declined rapidly by more than 4 percent; the Asian stock indices and the British FTSE also dropped significantly.

To understand the long-term impact of this development, it is crucial to understand the reasoning behind the decision. The Chinese government has announced several times that it will gradually increase the flexibility of the Chinese currency market. To fulfil this announcement, the People’s Bank of China changed the calculation of the daily renminbi fixing on Tuesday. They explained their intention to give greater weight to market forces in their rate-setting decisions, and in particular, they are taking the midpoint from market-makers’ quotes, including closing prices in the previous day’s trading sessions, into account. They furthermore announced that in contrast to previous years, the influence of market expectations is increasing.

In previous years the People’s Bank of China pegged their currency to the US-Dollar. As part of its historical transition from central planning to a market economy, China has massively increased its participation in foreign trade. However, while liberalising trade in some respects, Chinese trade policy remained highly interventionist in other ways: By intervening in the exchange rate market and by constantly depreciating the renminbi, the government tried to increase the level of competitiveness of the Chinese economy.

Since 2006, the People’s Bank of China has allowed the renminbi exchange rate to float within a narrow corridor around a fixed base rate determined with reference to a basket of world currencies, a tiny step towards liberalisation.

Still, the renminbi’s official exchange rate has been estimated to be undervalued by as much as one third in order to support Chinese exporters. As a result of appreciation measures by the Chinese government as well as unconventional monetary policy measures (especially quantitative easing) elsewhere, a depreciation of leading economies’ currencies started. Consequently, the Chinese renminbi appreciated substantially.

With respect to the weakened trade figures in China and its current economic performance (which is at a 25-year low) it is obvious that the market participants are going to expect a depreciation of its currency. Furthermore, it can be reasonably assumed that the burst of the asset price bubble in the Chinese stock market may also have played an important role explaining current developments. Additionally, government expenditure was jacked up, reflecting Beijing’s efforts to stimulate economic activity. Nevertheless, the People’s Bank of China pointed out that with respect to the international and domestic economic situation, there is currently no basis for a sustained depreciation trend for the renminbi. Moreover it is not necessary to be afraid of a so called worldwide “currency war” with long-term depreciations because in previous years the renminbi appreciated significantly and the current development is – as aforementioned – just a market driven correction. Nevertheless, other Asian currencies reacted dramatically.

In fact, the depreciation may have a stimulating effect on Chinas exports as China’s products will become cheaper for foreign consumers and investors. In response to the lower renminbi, Chinese steel producers have cut prices already.

The IMF is welcoming China’s step to relax the tight regulation of the renminbi exchange rate. The new adjustment of the renminbi exchange rate fixing towards a more market based approach increases the renminbi’s chance of becoming part of the International Monetary Fund’s basket of currencies.

Overall, a move away from protectionism and the implementation of a floating currency with market-determined exchange rates will give the critics of China’s exchange rate policy what they have long been clamouring for: An effective allocation of resources via supply and demand. Let the market decide on the ‘true’ exchange rate, not the government.