PBoC is navigating into uncharted waters on RMB

The People’s Bank of China’s bottom line of seven yuan per US dollar has been challenged a number of times since 2015 – the year the Chinese central bank sharply devalued the renminbi (RMB). However, market participants were still largely caught off-guard on Monday morning (August 5) as the psychological barrier, long held by the PBoC since April 2008, was broken, and was not recovered by market close that day.

The RMB’s exchange rate has been under tight management and is permitted to trade 2% on either side of a daily midpoint (the ‘fix’) set by the PBoC. Although in its official press statement the PBoC attributes the move through seven yuan to the US dollar mainly due to fluctuations in the market due to demand and supply, it appears clear this threshold would not have been breached had the central bank been determined to defend the line. For instance, it burnt through $107 billion (more than Malaysia’s entire foreign exchange reserves) in a single month in 2016 to stabilise the market after it devalued the RMB rather abruptly in August 2015. 

According to some reports, depreciating the renminbi is a major instrument for China in offsetting new punitive tariffs unveiled by the US on Friday. The potential impact of the 10% extra tariff on some $300 billion of additional Chinese goods, to be imposed in September, is roughly equal to 1–1.5% of renminbi appreciation. Hence, a move in the opposite direction in the exchange rate makes sense – although PBoC governor Yi Gang publicly vowed to maintain a stable renminbi against a basket of currencies. The US Treasury, meanwhile, has labelled China a “currency manipulator”.

Private communications with PBoC officials suggest that the move in the exchange rate was not the central bank’s preference, but the government had no better alternative. The exchange rate, the external price of the currency, tends to have a sweeping, across-the-board impact upon the economy. While it works as a trade remedy to a certain extent, the central bank also worries about its negative impact on its policy goals. 

PBoC’s hands are tied

A devaluation at this particular juncture is likely to further push up China’s domestic inflation, which has already been rising (it was 2.7% in June), mainly due to disruptive food supply, particularly staples such as pork. Consequentially, the PBoC’s hands on monetary policy are also bound, since an interest rate hike would largely choke a fragile economy when the GDP posted its smallest gain since 1992 (6.2%) in the second quarter of 2019. 

It will also make it even more difficult for the already heavily indebted state-owned enterprises and local governments in repaying their debt.

This is not to mention the huge pressure on the part of the central bank in stemming a capital flight panic triggered by a cheaper currency. Although the central bank has demonstrated its capacity to control capital flows in the aftermath of the 2015 saga, this has been achieved by harsh measures often at the expense of legitimate trade and investment needs of individuals and corporations. 

On the macro level, devaluation essentially works as tax on net importers, which, in China’s case, are households. Thus it appears contrary to China’s goal of rebalancing the economy away from investment to private consumption.

The RMB losing its psychological ground to exceed seven to the dollar might also be bad news for international central banks and the global economy. It represents weaker demand from China, and therefore will likely represent a drag on global economic growth.

The RMB losing its psychological ground to exceed seven to the dollar might also be bad news for international central banks and the global economy

Looming currency war?

In the short to medium term, China resorting to currency depreciation is essentially spreading the cost of US tariffs on to all of its trading partners, which is likely to trigger a currency war through competitive devaluation. Asian economies are likely to follow China’s steps if past experiences hold. A number of countries in South-east Asia are major beneficiaries of a supply chain restructuring due to the US-China trade war, and would not like to lose momentum due to currency moves. The interesting cases to watch are South Korea, Vietnam, Thailand and Indonesia.

Advanced economies are also unlikely to be happy with a corresponding appreciation of their currencies against the renminbi. The European Central Bank, for example, has managed to gradually offset the RMB’s devaluation against the euro after 2015. Beijing’s latest move will lead to similar reactions. The ECB has, in fact, signalled a rate cut, with renewed asset purchases on the table; and the Bank of Japan has offered its support of a government stimulus programme to be announced in October.

More importantly, Beijing’s move will strengthen the increasingly dovish outlook of the US Federal Reserve. A potential easing cycle of its monetary policy, however ‘mini’ it will be, could lead to a “full-blown currency war”, according to investment manager Pimco.

Beijing and its central bank need to think carefully and act responsibly as the renminbi is steered into uncharted waters. An international currency war will cause tension and jeopardise recovery from the global financial crisis, which China has every reason to want to avoid. The PBoC tried to reassure the market that it “has experience, confidence and capacity to maintain renminbi exchange rate at a reasonably stable equilibrium”. 

A more credible way out for the ‘post-seven era’ perhaps, is not for the government to weigh in, but to gradually wind down its market intervention. This will entail meaningful reforms of China’s trade practice and monetary regime, which will forge a fundamental anchor of its currency and the global economy.