Is China shifting policy to devalue the renminbi?

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Trade conflicts are currently raising the risk of another round of currency wars. Market suspicion about the People’s Bank of China (PBoC) shifting to a currency devaluation policy in China’s trade tussle with the US has intensified since June as Sino-US trade tensions escalated. Indeed, when US President Donald Trump criticised China (and Europe) on 19 and 20 July for manipulating their currencies to gain a competitive advantage, the PBoC set the renminbi (CNY/USD) fixing on 20 July almost one percent lower than the previous close.

Let’s test the devaluation proposition by examining the PBoC’s renminbi fixing, which involved three elements:

  1. The CNY/USD’s spot closing rate as of 4:30pm of the previous trading day
  2. The average of the 24-hour daily changes in the US dollar against the currencies in the China Foreign Exchange Trade System (CFETS) basket, the Bank for International Settlements (BIS) CNY basket and the International Monetary Fund (IMF) special drawing rights (SDR) basket
  3. A ‘counter-cyclical factor’ that accommodates the PBoC’s discretion in adjusting the fixing based on its judgement of supply and demand conditions in currency markets, risk appetite and international developments.

The first two elements reflect market forces driving the renminbi’s rate. The third part of the fixing was always there, but it was formalised as a counter-cyclical factor (CF) in May 2017 for Beijing to manage currency volatility not reflecting economic fundamentals[1]. The CF is a policy factor that can help assess whether the PBoC is engaging in devaluation.

Estimating the counter-cyclical renminbi factor factor

The first two parts of the fixing are observable, but the PBoC has never disclosed its calculation of the CF. We can estimate it by making the following observations and assumptions:

The fixing is determined by 1) market forces as reflected by the previous day’s close (denoted as “t-1” below) of the CNY/USD cross-rate and the average change of the currency baskets monitored by the PBoC and; 2) the CF on the day (denoted as “t” below) when the fixing is set. If we assume that the first two factors carry equal weight in the fixing calculation, this implies:

PBoC Fixingt = average DoD% of (CNY/USD)t-1 and (CFETS, BIS, SDR)t-1 + CFt

The only unknown here is the CF. We can do a back-calculation to estimate the CF by subtracting the implied CNY/USD cross-rate calculated from the previous day’s CNY/USD close and the average change of the currency baskets from the PBoC’s fixing:

CFt = PBoC Fixingt – {average DoD% of (CNY/USD)t-1 and (CFETS, BIS, SDR)t-1}

What does the estimated CF mean?

If the CF is negative, it means that the PBoC is using the CF to force the fixing to go against the market trend, though not necessarily overwhelming and reversing it. For example, according to the data, market forces implied a CNY/USD cross-rate of 6.855 on 20 July 2018, but the PBoC set the fixing at 6.759 that morning, or 0.095 stronger than market forces would warrant (6.759 – 6.855 = -0.095). Conversely, if the CF is positive, the PBoC is using it to steer market forces, thus reflecting a policy of pushing the currency along in the market direction, but by less than market forces would imply.

Where is the proof of a renminbi devaluation policy?

If the PBoC is pursuing a devaluation policy, we should see positive CF values as the central bank would have set the fixing higher (i.e. pushing the CNY weaker against the USD) than market forces would imply. A one-off devaluation should be reflected by a big positive jump in the CF value. But our estimate shows clearly that the PBoC has been using the CF to lean against renminbi depreciation (exhibit 1), as the estimated CF has developed a negative trend since June; i.e. the PBoC has been trying to slow the pace of CNY depreciation instead of pushing it lower.

On the other hand, when the renminbi was rising strongly against the USD between late 2017 and May 2018, the CF was also rising sharply, indicating that the PBoC was trying to slow the pace of appreciation by setting the fixing higher (i.e. pushing the renminbi lower) than the rates implied by market forces. In short, the counter-cyclical factor is aptly named.

Exhibit 1: CNY/USD cross-rate and PBoC’s counter-cyclical factor

renminbi CNY/USD cross-rate and PBoC's counter-cyclical factor

Note: 7-day moving average of PBoC fixing minus CNY/USD movement according to market forces (calculaed as DoD% of the avg of CNY/USD closing and RMB baskets’ closing). Sources: BNP Paribas Asset Management (Asia), as of 26/07/2018

There is no proof of the PBoC shifting to devaluation. But it seemed to use the sharp drop in the fixing on 20 July to send a message to the markets (and Trump) that, implicit in its no-devaluation pledge, is its ability to do so if it desires. If it had stepped back from the market, the renminbi would have fallen even further.

China has chosen a no-devaluation policy so far because, as I have argued repeatedly[2], devaluation would not be in its best interests. In a nutshell, by bolstering exports, renminbi devaluation would undermine Beijing’s goal of shifting the economic structure away from export-led investment-driven growth to consumption-led service-based growth. Furthermore, as US bond yields are currently rising, any devaluation move would run the risk of triggering massive capital outflows, echoing the nightmare in 2015-16.

In my view, while the prevailing trade tiffs may risk igniting another round of currency wars, renminbi devaluation remains unlikely.

To read more content written by Chi Lo, click here.

[1] See “Chi Flash: What Does the PBoC Introduce the “Countercyclical” Factor in Setting RMB Fixing?” 9 June 2017

[2] See “Chi Time: Questions About the Renminbi’s Stress,” 17 July 2018, “Chi on China: What Lies Beneath China’s Renminbi Shock?”, 9 September 2015, “Chi Time: Renminbi Devaluation Not China’s Best Option”, 7 May 2014, and “Chi on China: Up or Down? The Knowns and Unknowns of the RMB New Normal”, 28 January 2015

Chi Lo

Senior Economist for China

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