The three options for RMB policy
In the three weeks since its abrupt -3% devaluation, the renminbi has reverted to a remarkably narrow trading range against the US dollar. However, this rediscovered stability does not reflect any market belief that the renminbi is now appropriately valued following its modest fall.
On the contrary, it is the result of heavy intervention by the People’s Bank of China to keep the onshore spot rate steady at around CNY6.4 to the US dollar. In the near term, this fits with policymakers’ assertions that China’s exchange rate adjustment is complete (last week Premier Li Keqiang reiterated this stance, telling a delegation from Kazakhstan that the renminbi will not see “sustained depreciation”).
In the longer run however, repeated intervention to maintain the currency’s stability is at odds with the “more flexible exchange rate mechanism” the central bank announced just three weeks ago. This contradiction casts doubt over the PBOC’ s intentions: whether it is serious about moving to a more flexible currency regime, or whether it has simply re-imposed a de facto peg at a different level against the US dollar. As we see it, the central bank has three options:
1. Continued intervention to maintain exchange rate stability.
The objective of this strategy would be to reduce market expectations for further deprecation, as participants betting on further renminbi weakness capitulate in the face of the PBOC’s superior firepower. If successful, the PBOC could scale back its interventions, allowing the renminbi more leeway to float freely. The risk for the PBOC would be if its interventions fail to overcome depreciation expectations. In that case, it would have achieved little or nothing by last month’s move, which would neither have advanced exchange rate reform, nor introduced the greater degree of volatility the International Monetary Fund is demanding as a condition for the renminbi’s inclusion in the Special Drawing Rights basket. What’s more, failure would be expensive. With China’s capital account more open than in the past, and the central bank easing policy at home, intervention to maintain exchange rate stability is getting increasingly costly.
As daily turnover in the onshore spot market has shot up from US$15 bln to US$50 bln over the last few weeks, traders estimate that the PBOC and its agents have spent between US$100 and US$150 bln of China’s foreign reserves to maintain the renminbi’s exchange rate. Of course, with US$3.7 trln in reserves, in theory the central bank can go on intervening for years to come. However, policymakers will gain little by running down China’s reserves at a pace of US$150 bln a month. As a result, while the PBOC may adopt a strategy of continued intervention in the near term, say through President Xi Jinping’s visit to the United States later this month, it is not a viable course of action over the long term.
3. Scale depreciation.
2. Cease intervention and sizeable devaluation.
A large one-off move could have the merit of curtailing expectations for further depreciation. Following a -10% or -15% fall, significant renminbi buying interest would emerge, avoiding the feedback loop of capital outflows that would accompany a gradual depreciation. However, the costs entailed by such a strategy would be considerable. China’s leaders have repeatedly rejected the notion of competitive devaluation, so a large oneoff depreciation would be a diplomatic disaster, wrecking Beijing’s currency credibility.
Moreover, a big one-off devaluation would inflict severe damage on the balance sheets of those Chinese companies, including many state-owned enterprises, which have borrowed in US dollars without hedging their exchange rate risk.
Chinese policymakers prefer to move gradually whenever possible. Both interest rate liberalisation and capital account opening were pursued one step at a time, and when the consensus argued that the renminbi was deeply undervalued, the central bank only allowed a gradual appreciation. A gradual depreciation now would avoid inflicting a major shock on the economy, and so would be politically acceptable. However, there would be risks. A slow and protracted slide in the currency could heighten expectations for further depreciation to come, so fuelling self-reinforcing capital outflows—the opposite of the inflows attracted by the renminbi’s long years of slow appreciation.
Each strategy has risks. The current “peg and intervene” approach can work for a month or two, but can only be a stop-gap policy. The best outcome for the PBOC would be if its interventions allayed depreciation expectations and renminbi buyers re-emerged. However, that looks farfetched. Of the other two options, a gradual depreciation looks more likely than a one-off devaluation, not because of its economic merits, but because it is politically more acceptable and because experience argues for a gradualist approach. The risk is that it will just reinforce depreciation expectations.
What the PBOC really needs at this point is a weaker US dollar, but that of course, is beyond the reach of its policymaking.