Since late March 2016, the People’s Bank of China (PBoC) has set the reference US dollar renminbi exchange rate (CNY) progressively weaker, taking the onshore exchange value of the Chinese currency against the dollar to levels last seen at the beginning of the year.
At that time, devaluation of the currency to these levels set off alarm bells in financial markets, reviving concerns from last year that Chinese authorities would eventually undertake a major currency devaluation in order to improve export competitiveness and support flagging growth.
If past devaluations proved so disconcerting to global investors, why does the recent weakening of the currency to similar levels warrant nary a raised eyebrow? What is different this time? Admittedly, Chinese authorities have made a series of much smaller adjustments to the exchange rate compared to the early-January devaluation and similar instances last year (see exhibit 2 below). In addition, perhaps investors have simply gotten used to weaker currency settings by now – yesterday’s headlines are today’s old news.
Exhibit 1: Since late March the renminbi has depreciated against the US dollar, reaching levels last seen in January 2016 (the graph shows the USD CNY exchange rate - number Chinese yuan for one US dollar for the period from January 2016 through 10/06/16)
Source: Bloomberg, as at 10 June 2016.
However, a more fundamental shift in investor perceptions likely underlies the lack of focus on recent renminbi weakness. This shift in perceptions centers on two themes, China’s foreign exchange policy objectives and the role of capital account liberalization within the suite of China’s structural reforms. Regarding foreign exchange policy, investors have a greater understanding that China’s adherence to economic reform precludes a return to the 'old school' approach of supporting export-driven growth through a persistently weak currency. A recent interview in the People’s Daily with an “authoritative person” believed to be a high-ranking official, and that stressed the importance of progress on supply-side reforms, further supports this notion. With this in mind, investors have generally accepted the view communicated from PBoC officials that the central bank seeks broad stability in its trade-weighted currency basket unveiled late last year, as opposed to stability on CNY.
Seen in this light, CNY serves as the “release valve” to keep the basket broadly stable when the dollar appreciates against other currencies in the basket, rather than as a lever used to boost the export sector when domestic demand slips. Against this backdrop, investors do not see recent CNY devaluation as a worrisome response to worsening growth prospects. In addition, the release valve has not been needed as much recently, as declining expectations for sustained monetary policy tightening in the United States have limited the extent of dollar appreciation against other currencies in China’s trade-weighted basket.
The second shift in perceptions relates to the degree of capital account liberalization that Chinese authorities seek, now and in the future. Last year’s CNY devaluations sparked broad concern over possible capital flight from China, including on the part of nationals seeking to diversify their holdings away from domestic assets as growth faltered. This concern was based in part on an erroneous assumption that the International Monetary Fund’s decision to include the renminbi in the special drawing rights (SDR) basket meant that China could not roll back plans for increasing capital account liberalization. In reality, Chinese officials have prioritized stability over capital mobility, and capital account liberalization appears to have taken a back seat for the time being. Indeed, investors now broadly see the currency’s acceptance into the SDR basket as giving authorities greater flexibility to not only slow liberalization for the time being, but implement administrative measures to reduce the ability of citizens to send wealth abroad.
Exhibit 2: The Chinese yuan has renewed with the longer term trend towards depreciation
Source: Bloomberg, as at 10 June 2016.
Currently, non-deliverable forward contracts imply expectations for only modest CNY depreciation over the next twelve months. Clearly, investors are taking recent currency weakness in stride given their greater confidence that China does not seek to engage in a significant devaluation of the currency to support growth, and that authorities have the desire and the tools to limit capital outflows. But could investor expectations change, with future adjustments to the CNY fixing again proving destabilizing to global markets?
In one possible scenario, stronger growth and inflation prints in the United States could lead to a steeper anticipated path of policy tightening and a resumption of broad dollar appreciation. This is certainly not an immediate risk. Following a surprisingly weak May US payrolls report and a reduction in expectations for a policy rate increase by the Federal Reserve next week or in July, the resulting dollar weakness has been followed by the strongest fixing of the renminbi in over a month. Still, this event demonstrates the ongoing sensitivity of Chinese authorities to the exchange value of CNY within the broader context of its trade-weighted currency basket.
The PBoC would likely again react to such a development with persistently weaker fixings of CNY. In this event, would investors necessarily revert to their prior concerns about a larger devaluation? It could depend on the effectiveness of communications from the PBoC. Encouragingly, in 2016 senior central bank officials have improved their communications around foreign exchange policy. Still, we are not yet convinced that the central bank has fully embraced the positive role that communications can play in anchoring exchange rate expectations, and that it won’t revert to 'constructive ambiguity' that leaves investors uncertain of policy intentions. With the clarity of future central bank communications still a question mark, a renewed market focus on CNY devaluation cannot be ruled out. [divider] [/divider]
This article was first published in the Weekly Intelligence Report on 7 June 2016.