Will China continue to devalue its currency?
An overview of the new currency valuation methodology and its impact on China's plans for the future
On Tuesday August 11th, the People’s Bank of China (PBoC) announced it would change the way its currency is valued. The PBoC stated it would allow for greater market input in determining the value of the renminbi (RMB). The RMB subsequently depreciated by 1.86% against the U.S. dollar and an additional 0.96% the following day1.
While China’s move to devalue the RMB may have a modest benefit for its export market, we do not believe this was the primary motivation for making the change. China’s leadership has repeatedly mentioned their desire to increase domestic consumption and become less reliant on foreign demand for their exports. We believe the primary driver for the change in the RMB’s valuation methodology is furthering a key policy goal: RMB internationalization.
How devaluation benefits China
Although China is making a concerted move toward increased domestic consumption, exports still account for about 23% of China’s total GDP2. Exports have been declining in China due to the global economic slowdown and the rise in the RMB’s value versus the currencies of its trading partners. According to estimates from Bloomberg, for every percent decrease in RMB value there is a corresponding one percent increase in China’s total exports.3
The devaluation of the RMB has a greater effect on the RMB’s exchange rate with the Euro than the U.S. dollar. In Euro terms, the devaluation was 2.63% on August 11th and 1.79% on the 12th4. For the week, the Euro exchange rate lost 4.8% versus 3.0% for the USD5. Devaluation makes China’s exports more attractive for its largest trading partner, the European Union, less so for the United States.
The PBoC’s previous method of setting the price for the RMB had grown to be increasingly expensive as the U.S. dollar strengthened. This was exacerbated in June and July when the PBoC increased the supply of RMB in order to inject capital into China’s equity markets. The PBoC’s intervention largely achieved its goal of supporting the market, but it also increased the cost of the RMB peg at the same time. Raising money to maintain a strong RMB is one explanation for why China sold $180 billion of its U.S. treasury holdings in the second quarter of 20156. By devaluing its currency China can lessen its need to deplete reserves and maintain greater flexibility in supporting the markets.
Why we believe China will not pursue prolonged devaluation
Devaluation will undoubtedly have some GDP boosting effect and also help China mitigate the cost of increasing the supply of RMB. However, we believe these benefits are secondary to China’s much greater goal of RMB internationalization. One forthcoming milestone in its path to achieving this goal is The RMB’s inclusion into the International Monetary Fund (IMF)’s Special Drawing Rights (SDR); a basket of international reserve currencies. If the RMB is included in this elite group of currencies, central banks from around the world will be required to hold China’s currency in reserve and the RMB will gain legitimacy as a predominant global monetary unit alongside the Dollar, Pound, Euro and Yen.
The RMB’s possible inclusion in the SDR will not only increase demand for China’s currency, it will also substantially decrease China’s cost for conducting international trade. Once the RMB is held as a reserve currency, China’s transactions with its trading partners can be settled directly in RMB without having to be first converted to another reserve currency, such as the U.S. dollar. China’s savings will be significant as it surpassed the United States as the world’s largest trading nation in 2013 and the total amount of its exports and imports reached $4.3 trillion in 2014.7
China’s decision to let the markets set the value of its currency came a week after the IMF issued its “initial considerations for the valuation of the SDR” on August third. In its report the IMF commended China for the progress it has made toward the free usability of the RMB. However it said the RMB still lagged behind the other four currencies and that “availability of representative market-based exchange and interest rates is essential for the proper functioning of the SDR basket”8. We believe this language spurred the PBoC to take swift action.
In order to address the IMF’s concerns the PBoC initiated the following policy: At the end of each day, around 10-20 market makers, comprised of major domestic and foreign banks, give their prices for the RMB based on their perception of supply and demand and the RMB closing price from the previous day. The PBoC then takes the average of these prices to determine the “midpoint”. The RMB is subsequently allowed to fluctuate up or down 2% from the midpoint the next day. This band gives the market more room to move the currency and we believe should help address some of the IMF’s lingering free-usability concerns9.
China already has a model for what a freely usable RMB might look like. Many investors are unaware that there are actually two different currency markets for the RMB. There is the CNY market, which is RMB traded within Mainland China, and there is the CNH market, which is RMB traded offshore.
CNY is subject to all Mainland Chinese regulations and the CNY FX (foreign exchange) rate can only be accessed offshore for documented goods traded directly with Mainland China. The CNH market represents the majority of RMB transactions outside of China. There are no special controls in the offshore market and CNH conforms to prevailing market practice for foreign currencies. With the PBoC’s recent actions to let market forces set the value of the RMB, the disparity between the CNY and CNH markets could diminish.
Further reasons to keep a strong RMB
Finally, China is hesitant to pursue a policy of extended devaluation because it does not want to encourage capital flight from its economy. The decrease in the RMB’s value also decreases the value of capital invested in China. This will impact domestic investors and foreign companies who have substantial holdings in China. China’s leadership is especially concerned about foreign companies exiting China because there are less controls in place to prevent them from leaving.
There has been significant growth in foreign research and development (R&D) facilities in China in recent years. Increased R&D feeds into Chinese Premier Li Keqiang’s plan to encourage mass innovation and “foster a new engine of growth”10 for the Chinese economy. According to a 2013 report from KPMG11, multinational companies now operate 1,300 of China’s 1,600 R&D centers. The proliferation of multinational R&D facilities has been beneficial for both Chinese and international companies. China gets international knowledge to help “move up the value chain” with the goods that it produces and foreigners get to tap the Chinese domestic market with products tailored for Chinese consumers. A prolonged period of devaluation for the RMB would make the Chinese domestic market less appealing for multinational investment, and would hurt China’s long-term goals.
Recent volatility in global markets reflects uncertainty about the impact of diverging central bank policies around the world. With the U.S. economy leading the global recovery of the past six years, rates will gradually rise, beginning as early as September. With a transparent U.S. Federal Reserve and increasing likelihood for a U.S. rate hike in the months ahead, much of the market effect on global stocks and bonds is likely priced in.
In China, pockets of volatility may still persist in the onshore markets. We believe things should normalize in the near future as the market becomes accustomed to the new changes. We believe the RMB’s designation as a reserve currency could mean a boon for the Chinese economy as it will significantly decrease the cost of international transactions and demand for China’s currency should accelerate. China’s leadership is taking the necessary steps to open up its economy for substantial growth in the years and decades to come.
- Data from Bloomberg, as of August 12th 2015
- Data from World Bank, as of December 31, 2014
- Data from Bloomberg, as of August 19th 2015
- Data from Bloomberg, as of August 12th 2015
- Data from Bloomberg, as of August 17th 2015
- Daniel Kruger and Wes Goodman (August 10th 2015 ) ”China Slashes U.S. Debt Stake by $180 Billion, Bonds Shrug”, Bloomberg
- Data from Wind, as of Jan 15th 2015
- (August 3rd 2015) “REVIEW OF THE METHOD OF THE VALUATION OF THE SDR—INITIAL CONSIDERATIONS”, International Monetary Fund
- Yi Gang (August 13th 2015) “PBoC press briefing about the new CNY/USD central parity mechanism”, People’s Bank of China
- (August 9th 2015) “Fostering new engines of growth”, The State Council of China
- (August 2013) “Innovated in China: New frontier for global R&D”, KPMG