What's behind the RMB devaluation fears again?

ON Jan 7, the PBOC set the USD-CNY fixing 0.5 per cent weaker than the previous day, the biggest decline since the Aug 11, 2015 move when the PBOC changed the calculation mechanism for the fixing. This set off another round of renminbi (RMB) devaluation fears, triggering a second sell-off of A-shares which caused the circuit breakers to kick in and halt the day's trading for the second time in just four days.

In fact, the RMB onshore exchange rate has dropped against the USD by 1.5 per cent between Jan 1 and Jan 6, a huge move by its standard. So, when the PBOC lowered the fixing on Jan 7 by a larger than usual extent (0.5 per cent), it revived fears of an imminent RMB devaluation. Some even feared that the PBOC might be losing control of the financial system.

I, still, stubbornly think that these fears are exaggerated. But it is true that the PBOC might have shifted its FX policy to tolerate more decline of the RMB against the USD for a good reason that we have argued earlier. The problem does not lie in the policy shift, but in the lack of clear policy communication by the PBOC.

The PBOC used to intervene heavily whenever there is a 2 per cent-3 per cent move in the FX market. But since the RMB joined the IMF's Special Drawing Rights last December, it has stepped back from intervention; but it has not communicated with the market what its policy intentions are.

There is also a view that Beijing might have lost control of growth, which has been decelerating, so it would need an RMB devaluation to boost growth. We have argued repeatedly that devaluation is not the best option, as it will not solve China's growth problem.

Today's slowing growth stems from the domestic sector, which is going through expenditure-switching from manufacturing to consumption, but not from the export sector. This structural change is causing the old (manufacturing/industrial oriented) sector to contract, while the new (service oriented) sector has not yet grown strong enough to pick up the slack. But this is creative destruction, and RMB devaluation is not a solution to the growth slowdown.

Meanwhile, pegging the RMB against USD becomes costly when the world turns against the RMB and capital flows out of China. This is because the resultant loss of FX reserves becomes a passive liquidity drain, which hurts GDP growth. So allowing the RMB to fall against the USD is more about helping to relax this passive liquidity constraint than boosting exports. This is different from a policy of joining the currency war by devaluing the RMB.

What is happening is that, the PBOC may have shifted the target of its FX policy towards a trade-weighted exchange rate from the USD. So it introduced the CFETS (China Foreign Exchange Trading System) exchange rate index last December, which is based on a basket of 13 currencies, as a reference to conducting FX policy.

In fact, the RMB's trade-weighted exchange rate has remained quite stable since Christmas, when the USD's trade-weighted exchange rate has risen. This implies that much of the RMB's recent decline against the USD might have been a move to keep the RMB's trade-weighted exchange rate stable in the face of a strong USD.

By implication, this also suggests that the PBOC might have targeted a stable trade-weighted exchange rate, ie keeping the CFETS index at around 100. If this is the case, then it is allowing the USD-CNY cross rate to move more freely to keep the index near the target.

A more market-driven FX framework is indeed a sign of progress of China's monetary reform. But a clear policy message has to be communicated to the market to prevent the worry about competitive devaluation from recurring.

At this juncture, the market has no clue about the PBOC's FX policy goal: Does it want to target a stable RMB's trade-weighted exchange rate, or does it want to keep the trade-weighted exchange rate in a range, and what is the bandwidth of the targetted range?

If the PBOC is targeting a stable trade-weighted exchange rate, with the CFETS index staying at 100 for 2016, this would imply further CNY depreciation towards 6.8 - 6.9 per USD (or another 3.2 per cent of decline from today's 6.5888 CNY-USD cross rate). The movement of the USD against other currencies will determine how much the RMB-USD cross rate will move and in what direction. But the PBOC needs to communicate its policy intention clearly to minimise market volatility.

China's FX policy shift towards tracking a trade-weighted exchange rate could have far reaching implications for Asian currencies. In the old FX policy regime when China targeted a stable USD-RMB cross rate, Asian currencies could devalue against the USD and the RMB at the same time to gain export competitiveness.

But if the PBOC is severing the RMB's tie with the USD and shifting to target its trade-weighted exchange rate, it would not be easy for the Asian countries to devalue against the RMB. At this point, the PBOC has not formally announced its policy shift, and empirical research shows that the PBOC has not used the CFETS index as a hard policy target. The market's adjustment to China's new FX policy and China's adjustment to managing market forces have just begun.

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