China's juggling act on the yuan

China's move to devalue the yuan this week has caused turmoil in the currency and stock markets. Here, one writer says the move is consistent with China's wish to internationalise the yuan, while another warns of the adverse impact of devaluation on the stock market and foreign debt.

Letting the market play a bigger role

Alice de Jonge
Monash University

China wants to be an international player, and to be an international power it needs the Chinese yuan to be an international currency.

Tuesday's announcement by the People's Bank of China (PBOC) that it was reforming its daily US dollar/Chinese yuan mid-point fixing mechanism was simply another step along the path to yuan internationalisation. Of course, it was a reform that was also very cleverly timed to weaken the yuan, when a weaker yuan is just what China needs to slow the decline in Chinese exports.

The first big step towards internationalising the yuan came in 1994 when, as part of a break from communist state planning, Beijing let the currency fall by one-third. For the next decade, the Chinese authorities held to a hard peg that valued the US dollar at 8.28 yuan.

Given the size of China’s economy, and the large size of its foreign exchange reserves, China can control its exchange rate more effectively than most countries can. PHOTO: BLOOMBERG

Then on July 21, 2005, China's central bank announced that it had removed the hard peg - a move that initially served to push the dollar down to 8.11 yuan. Since then, the yuan has continued to rise against the dollar, so that by last month, the Chinese currency had risen about 33 per cent against the dollar over the decade.

Before Tuesday, China's central bank set a mid-point for the value of the yuan against the dollar, called the daily fixing. The yuan is allowed to move 2 per cent above or below the daily fixing in daily trading.

But the PBOC has never been clear on what criteria it takes into account when setting the daily fixing. In particular, the PBOC has sometimes ignored daily moves so that, for example, when the market indicates the yuan should be weaker against the dollar, the daily fixing is set to make it stronger. So, the strategy of fixing the yuan has, for quite a while now, actually allowed it to diverge considerably from the market rate.

With Tuesday's announcement, the fixing will now be much more aligned to the market, in that it will be based on how the yuan closes in the previous trading session.

The most immediate result of this new policy on Tuesday was that the yuan's fixing was weakened by 1.9 per cent from the previous day, leaving it at 6.2298 to the US dollar, compared with 6.1162 on Monday. Another 1.62 per cent devaluation was applied on Wednesday.

So, while US Republicans and much of the media are yet again declaiming against the undervaluation of the yuan - a nasty Chinese strategy to sell its goods at artificially cheap rates on the world market - in fact, the yuan's mid-point has now become much more market-based.

In other words, the PBOC has done what long-time critics of China's currency policy have long been clamouring for - let the market play a bigger role in deciding the yuan's value.

What is the overall impact of the recent alteration in rate-setting policy and consequent devaluation? First, it is another step towards a more open and international Chinese economy.

The International Monetary Fund (IMF) said: "The exact impact will depend on how the new mechanism is implemented in practice. Greater exchange rate flexibility is important for China as it strives to give market forces a decisive role in the economy, and is rapidly integrating into global financial markets."

How the new mechanism is implemented will also influence the extent to which it will assist China's desire to have the IMF declare the yuan an official reserve currency, on a par with the US dollar, euro, yen and pound.

In the short term, the change will give a shot in the arm to Chinese exports, especially to Europe. Chinese exports to Europe have suffered as the yuan has followed the US dollar in appreciating against the euro.

Another short-term impact will be the fluster that is caused in US politics. The devaluation of the yuan will pose a dilemma for the United States Federal Reserve, which is preparing to raise interest rates later this year, but is concerned by the continuing strength of the US dollar - concern that is now deepened because the Chinese move puts further upward pressure on the dollar.

US politicians will also rail against what they see as another example of China's broken promises to refrain from intervening in exchange markets.

But it should always be kept in mind that, given the size of China's economy, and the large size of its foreign exchange reserves, China can control its exchange rate more effectively than most countries can. The main concern for the Chinese authorities is to retain control over "hot money" flows - speculative flows of money chasing interest and chasing currencies expected to appreciate.

These cause the greatest damage when they flow out of currencies expected to depreciate, as occurred during the Asian financial crisis of 1997, which China observed closely, but was able to protect itself against.

A tightrope walk with risks

William Pesek
Bloomberg View

Chinese President Xi Jinping has just added a chainsaw to what was already a pretty daunting juggling act. All year, he's been trying to keep aloft two giant economic bubbles - one in debt, one in stocks. This week, he added a much more unwieldy prop, the value of the yuan, to the show.

China is entirely justified in lowering its exchange rate, so far by 2.8 per cent. It's a risky move, but worth taking if it stabilises the world's second-biggest economy and nudges it towards a market-determined financial system - assuming Mr Xi's team truly knows what it's doing.

The problem for China's President is that this latest challenge threatens his ability to manage the other two. As China guides its currency lower, it heightens default risks on foreign-currency debt, and increases the odds of capital flight, which would slam stock prices.

It's not that China lacks latitude to devalue its currency. Before Tuesday's 1.9 per cent cut in the central bank's reference rate, the yuan had risen about 15 per cent, on a trade-weighted basis, in 12 months. But there are other considerations that should constrain Chinese policy.

The Group of Seven nations would throw a fit if China lowered the yuan's value any further; China could even become a target for candidates in the 2016 United States presidential election.

That is why Wednesday's devaluation raised more questions than it answers.

The whole idea of devaluing is to do it all at once - make a huge, one-time step, ride out the turbulence and move on.

China, it appears, favours a drip-by-drip approach. That could dent the market's confidence in the country's policymakers.

Will investors, analysts, risk managers, executives and journalists feel they can still rely on Chinese pronouncements, or will they have to sit on pins and needles every morning, waiting to see how much the People's Bank of China lops off the yuan?

As Bridgewater Associates hedge fund manager Ray Dalio sees it, Beijing's "promises to defend it here will need to be kept or it will lead to a loss of credibility - like the implied promise to support the stock market at around 3,500 needs to be defended or it will lead to the appearance that the marketplace is more powerful than the government".

Beijing has already shown its inability to adequately manage the country's stock prices, and levels of debt. Currency markets may likewise demonstrate Beijing's impotence. China could end the drama by stating clearly that the yuan's big declines are over for now. That would calm nerves in markets and head off a brewing geopolitical storm of protest and copycat devaluations. The central bank may have done just that on Wednesday, intervening to prevent the yuan from going too far.

Amid these discussions, Washington finds itself caught in an ironic position. For years, the US criticised China for not letting markets decide the yuan's value, on the assumption that it was undervalued. Now that traders have a bigger say, the yuan is moving down. Nonetheless, there comes a point where China will need to take economic realpolitik into account.

The benefits from a weaker yuan will fade quickly if the world fears Beijing is acting rashly or further huge drops are coming. And if Mr Xi fails at managing the course of China's currency, his entire juggling act will come to an untimely end.

A version of this article appeared in the print edition of The Straits Times on August 14, 2015, with the headline 'Letting the market play a bigger role A tightrope walk with risks China's juggling act on the yuan'. Print Edition | Subscribe