China to devalue its currency further
IPrepared by Camille Accad
n the last twelve months, most emerging markets’ currencies depreciated against the US dollar, helping improve their competitiveness. However, economies with a US dollar peg appreciated against other currencies. These include the export-intensive GCC countries, Hong Kong and China, which may face additional appreciation pressure after the Federal Reserve raised interest rates.
China has already acted to reverse the appreciation trend. In August, the central bank devalued the yuan following a change in the way it determines the country’s foreign exchange rate, which includes taking into consideration other major currency movements rather than just the US dollar. Since then, the yuan depreciated around 4% against the US dollar, the largest fivemonth drop in over twenty years. Ten days ago, the central bank unveiled a new currency index: the China foreign exchange trade system (CFETS) RMB index. The index will be based on a basket of 13 currencies, with the US dollar given a weight of 26.4%, the yen 21.4% and the euro 14.7%. The CFETS RMB index will be used as an additional reference point for the central bank to determine the value of the yuan and to manage market expectations.
The release of the CFETS RMB index is a signal to the market that the central bank still considers the yuan as overvalued. In the last twelve months, the index appreciated 2.9%, compared with a depreciation of 4.4% for the yuan against the US dollar. The index was also introduced one week before the Federal Reserve decided to raise interest rates, a move that is expected to appreciate the US dollar further – and hence the Chinese yuan against its trade partners’ currencies. China’s move can be read as a central bank signal to the market that it plans to devalue its currency further.
China needs the stimulus boost from a currency devaluation. Exports have been contracting in nine out of the eleven first months of this year, forcing some companies to cut prices and subsequently lower wages in order to become more competitive. Moreover, in order to maintain the soft peg, the central bank has been using foreign exchange reserves to buy yuan from banks, draining liquidity from the financial system and leading to a 10% decline in foreign reserves compared to last year.
A more flexible exchange rate is also in line with China’s long-term objective to liberalize its currency and remove capital controls. Having already joined the IMF’s SDR basket, China’s willingness to reduce its currency link to the US dollar is a step forward in the yuan’s internationalization process. Monetary policy would also become less dependent on the Federal Reserve. By letting the yuan devalue, the central bank would have to intervene less in the foreign exchange market allowing for the more complete transmission of Chinese monetary loosening. Given the policy divergence between China and the US, the effect on the economy would be evident.
The announcement of the CFETS index is an implicit warning to markets that the central bank is planning to devalue the yuan as China needs to strengthen its large export sector without causing market stress. By not having to intervene in forex, monetary policy easing could have a greater effect on the economy and China’s goal to internationalize the yuan will remain on track. However, the country still has a long way to go before it can free-float its currency as destabilizing capital outflows as a result of removed capital controls remain a significant risk. For now, China is focusing on stimulating the economy before it resumes its gradual implementation of reforms.