Zhang Ming, PhD, Director in the international investment research office of the Institute of World Economy and Politics, Chinese Academy of Social Sciences (CASS), Beijing

A version of this article was originally published in the Business Standard as ‘How China can resist devaluation pressure’, 29 July 2017. This is part of a series by Chinese economists facilitated by the ICS.

In July 2005, People’s Bank of China announced it was implementing a managed floating exchange rate system based on market principles and with reference to a basket of currencies.

From the end of June 2005 to the end of July 2015, RMB exchange rate against the US dollar rose to 6.12 from the previous 8.28, appreciating by about 26% (Figure 1). The RMB nominal effective exchange rate (NEER) and real effective exchange rate (REER) indices appreciated by 48% and 57% respectively over the same period (Figure 2).

That the appreciation of the REER of RMB exceeded its NEER indicates that the inflation level in China during this period was higher than the global average.

Figure 1: RMB exchange rate against USD

 

Source: CEIC Data

Figure 2: Changes in the effective exchange rate of RMB

 

Source: Bank for International Settlements

Between 2008 and 2014, the effective exchange rate for RMB registered a steep appreciation, during which the RMB exchange rate against US dollar remained stable (Figure 2). Therefore, the rapid appreciation of the RMB effective exchange rate was mainly due to the rapid appreciation of the US dollar against other currencies.

However, while the strong appreciation of the RMB’s effective exchange rate in 2008 was supported by the fundamentals of China’s economy, a similar appreciation in 2014 was a distinct deviation given the subsequent decline in China’s economic fundamentals. This is why since the second quarter of 2014, depreciation expectations have taken hold with RMB appreciation against the US dollar in the market expected to be reversed.

In August 2015, the People’s Bank of China announced reforms in the RMB exchange rate regime again with the reform focus this time on the daily opening price of the RMB against the US dollar in the foreign exchange market.

Before the exchange reform in August 2015, the central bank prevented excessive appreciation (or depreciation) of RMB against the US dollar on a regular basis by artificially lowering (or raising) the daily opening rate of RMB against the US dollar. In order to promote the RMB’s entry into IMF’s SDR currency basket however, the essential aspect of the 2015 exchange reform was that the central bank would voluntarily give up its intervention in the daily opening rate of RMB against the US dollar.

At the beginning of this reform process, the daily opening price of RMB against US dollar was set at the closing price of RMB against the dollar for the previous day. However, as the RMB faced significant devaluation pressure in the markets at the time, the decision of the central bank to abandon intervention in the opening price resulted in significant depreciation of the RMB against the US dollar exchange rate. From the end of July 2015 to the end of March 2017, the RMB weakened against the US dollar with the exchange rate falling from 6.12 to 6.89, devaluing RMB by 13% (Figure 1). During the same period, the effective exchange rate of RMB also depreciated remarkably.

As the Chinese government has gradually liberalized the capital account, the depreciation outlook for the RMB is now expected to reverse. China’s previous net inflow of private capital has turned into an outflow; China had a sustained capital account deficit from the Q2 of 2014 to Q4 of 2016 (Figure 3) with the net outflow of private capital reaching US$984.8 billion during this period.

Figure 3: China’s quarterly international balance of payments

Source: CEIC Data

To avoid the potential risks of the rapid devaluation of the RMB against the US dollar, the central bank has adopted three new approaches since the RMB exchange rate reforms of August 2015.

First, the central bank has frequently bought RMB and sold dollars in the foreign exchange market to stabilize the RMB exchange rate. As a result, China’s foreign exchange reserves have contracted falling from a peak of about US$4 trillion in late 2014 to about US$3 trillion at present, down by about 25% (Figure 4).

Second, China’s central bank now fixes the daily opening price of RMB against the US dollar taking into account two factors with respect to the daily opening price of RMB against the US dollar. In addition to the RMB’s closing price against the US dollar the previous day, it also maintains RMB’s effective exchange rate against 24 other foreign currencies based on a 15-hour reference period before the opening of the working day. Both factors have equal weightage.

Third, China’s central bank has significantly strengthened regulation of capital outflows.

Figure 4: China’s foreign exchange reserves

     Source: CEIC Data

For a large open economy such as China, the most appropriate exchange rate regime is a free floating one. China’s central bank should further strengthen the flexibility of the RMB exchange system, so that the exchange rate will be determined by market supply and demand to a greater extent. This means that the People’s Bank of China should reduce or even abolish intervention in the foreign exchange market. It may result in a significant devaluation of RMB against the US dollar in the short term, but it would also avoid excessive consumption in the foreign exchange market and strengthen the independence of the central bank’s monetary policy. Weighing all the pros and cons, this may be the more sensible choice for China’s central bank.