Tu Yonghong: Perspectives on the RMB Depreciation under the New Exchange Rate Formation Mechanism

2017-01-16 IMI

This article is published on Theoretical Horizon, No. 11, 2016. Tu Yonghong: Deputy Director of IMI, Professor of School of Finance at Renmin University of China Translated by Liao Yiqi, Research Assistant of IMI Abstract: The RMB depreciation this year is a result of the dual factors of regime transition and market projection. The fundamentals of China’s economy remain unchanged, and the short-term devaluation trend will be reversed soon. A transparent and managed floating exchange rate system is favorable for the market to adjust the balance of payments, and endowed the central bank with more independence in making monetary policies. The system also helps to improve China’s macroeconomic management capabilities, and provides institutional guarantee to a stable and robust economic growth. Keywords: Exchange Rate Formation Mechanism, Reform, RMB, Depreciation In August 2015, after China implemented reform on the exchange rate formation mechanism, RMB exchange rate saw flexible two-way fluctuations and showed a depreciation tendency with occasional depreciations, which sparked market concerns. What is the correlation between this round of devaluation and the exchange rate reform? Will RMB continue depreciating? Should investors exchange RMB for foreign currency to ensure higher profits in overseas investment? Will China’s economy be debilitated as a result? Questions like these have become the most contentious topics in the society. This paper holds that the RMB depreciation this year is a result of the dual factors of the regime transition and market projection. The fundamentals of China’s economy remain unchanged, and the short-term devaluation trend will be reversed soon. A managed floating exchange rate system is favorable for the market to adjust the balance of payments, and endowed the central bank with more independence in making monetary policies. The system also helps to improve China’s macroeconomic management, and provides institutional guarantee to a stable and robust economic growth. 1.RMB depreciation attracts wide attention Exchange rate is the barometer of international economic activities. The fluctuations of exchange rate are reflection of trade and capital movements, and also an important means of adjusting the balance of payments. As the home currency of the second largest economy and the largest trading country, RMB’s depreciation and appreciation have direct implications on importers and exporters, investors, wealth managers and overseas tourists, and could spill over to the economies of China’s major trading partners. After a decade of unilateral appreciation, RMB is experiencing a turn of depreciation in 2016. Statistics from China Foreign Exchange Trade System (CFETS) shows that CFETS RMB Index on Oct 31, 2016 is 94.22, depreciated by 6.72% compared with the level of 100.94 at the start of the year. RMB's central parity rate against the U.S. dollar at the same period is 6.7641, devalued by 3.86% this year. On the contrary, driven by the recovery of the U.S. economy and the expectation of an interest rate increase on December, the dollar index is increased by 3.12% in October, a new yearly high, causing huge amounts of capital to flow back to the country. Under this impact, China saw an increase of the flight of arbitrage capital, and the foreign exchange reserves dropped from $3.5 trillion in August 2016 to $3.2 trillion in October 2016, a 9.4% decline in merely two months. This year, many uncertainties were added to the international financial landscape. Brexit and the Fed’s rate hike make the U.S. dollar a safe-haven currency, with the dollar index continuously rising and fully recovered from the drop after 2008 crisis. Meanwhile, panic swept China’s domestic market and rumors of RMB depreciation began to spread. To control risks and make speculative gains, some companies and individuals shunned the restrictions on foreign exchange and move out of RMB into the U.S. dollar with haste. Needless to say, such arbitraging behaviors increased the prospect of RMB’s depreciation and eventually made it become a reality that might otherwise not have been the case. A small stone could make a big splash. The changes of RMB exchange rate is in the interest of many people and has become a public concern both at home and abroad. Some believe that china’s economy is losing its steam in the new normal era; RMB depreciation and large scale of capital flight coiled up into a vicious cycle. Pessimists predicted that the exchange rate between the dollar and RMB would be up to 1: 7.5. Others held that the trend of capital flight propelled by the Fed’s rate hike and Brexit is ebbing, indicating the RMB depreciation is on a brake and the exchange rate against the U.S. dollar would not exceed the level of 6.82. More concerns were about the economic implications brought by the currency depreciation. Questions are amounting, for example, will RMB depreciation push up the prices of imported goods? Will prices of consumables like food and oil exacerbate inflation and squeeze people’s real income? Will the depreciation give impetus to the rich to transfer their wealth from home to abroad and add more stress to the already sluggish private investment, and as a result, undermine the driving force of the economy and make it harder to create jobs? If the RMB continues to depreciate, should people exchange RMB for foreign currency to retain the value of their assets? An even more severe concern is the effects caused on the real estate market by the large-scale capital flight. Is there a possibility for a liquidity crisis to happen again as it did in 2013 and would there be a financial turmoil as a result? What’s more, some foreign financial institutions and media hold a bearish view on China, expecting to make a short-sell of RMB for their own benefits. Several foreign scholars even accused China as a currency manipulator who adopted a begging-thy-neighbor strategy to facilitate export by devaluing the currency. Since the U.S. presidential campaign ended up with a conservative administration, China’s trade surplus with the U.S. is likely to be narrowed down. Expectations of the Fed’s rate hike this December can lead to a new round of capital flight from China. If that is the case, will RMB continue depreciating and reach the level of 7? How can China’s economy maintain its robustness and stability under a more flexible and risky exchange rate regime? To find answers to these questions, we need to figure out the evolution of formation mechanism of RMB exchange rate. 2. A more reasonable, transparent and market-based formation mechanism of RMB exchange rate Exchange rate is the price of a home currency offered to foreign-currency holders, and it is the most important market-adjuster in an open economy. History showed that China’s fast rise and economic miracles are indebted to its fundamental policy of reform and opening up. Unlike many other emerging economies, China adopted a gradual schedule to implement reform and opening up, rather than trying to achieve the ultimate goal once and for all. The reform of exchange rate is no exception. China has had four rounds of exchange rate reforms, achieving the transition from a fixed exchange rate regime under strict FX restrictions to a managed floating rate regime based on market supply and demand. It took 21 years for China to improve the RMB exchange rate system and formation mechanism, and to realize the goal of a market-based exchange rate. The first round of reform set up the floating system. In order to deepen international division of labor and share the globalization dividends, China abolished its long-time state distribution system of foreign exchange reserve on January 1994, implemented a system for the settlement and sale of FX under current accounts, aligned official and swap center rates and set up a market-based, unified, managed floating system. The reform abolished the multiple exchange rate and established a unified exchange rate system in which the central bank managed the exchange rate with reference to the daily trading band and the central parity rate. China, at that time, faced with reforms in SOEs, operation mechanisms and administration structures, needed to control risks from exchange rate fluctuations and build a favorable exterior environment for economic accounts. Uncertainties in foreign exchange amounted after 1997 Asia financial crisis and China's WTO entry in 2001. To minimize the negative impact to the vulnerable economy caused by fluctuations of exchange rate, the central bank strengthened its regulation in exchange rate. The daily trading band width was less than the 3‰ range, and the annual fluctuation of central parity rate is about 1%. The highly stable RMB exchange rate was seen by IMF as an indicator for a conventional fixed peg exchange rate arrangement. The second round of exchange rate reform introduced the market-determined mechanism. After China’s entry into WTO, export and FDI were gaining rapid growth, the international balance of payments improved greatly and the foreign exchange reserve doubled within 3 years. Western countries accused China of undervaluing RMB and pressed China to revalue the currency. The cost of stabilizing exchange rate was getting higher. The central bank was forced to buy FX reserves from the market, which increased the money supply and inflation pressure, and undermined the Chinese government’s macro-economic management capability. To permit a greater role for market forces in determining the RMB exchange rate and to allow exchange rate to perform its function in adjusting international balance of payments and to maintain independence in making monetary policies, measures have been taken since July 21 2005 by the central bank in reforming the exchange rate formation mechanism. Market-maker system was introduced and the five state-owned banks, 14 stock-holding banks and 7 foreign banks, with Standard Chartered Bank, Citi Bank, HSBC and Deutsche Bank included, were designated as the market makers. This round of reform established a market-based pricing mechanism in determining RMB central parity rate, allowing the value of RMB to fluctuate based on market supply and demand. To avoid following a Japanese-style hollowed-out economy induced by the yen’s sudden revaluation, and to avoid repeating the history of Japan’s “Lost Decade”, the PBoC still kept timely intervention in the exchange rate market to ensure a gradual appreciation of RMB. The third round of exchange rate reform widened the daily trading band and added flexibility. After the outbreak of 2008 financial crisis, global economic and financial framework has changed in many dimensions. After the Fed’s QE policy led to the devaluation of the U.S. dollar, to mitigate exchange losses, China embarked on RMB internalization in 2009. Meanwhile, China became the driver of world economy. Large amounts of capital gravitated to China due to the high rate of return on investment, driving the FX reserve up to $ 3.9 trillion and fuelling the expectation of RMB’s appreciation. On June 19 2010, the central bank kept improving the exchange rate formation mechanism and made the exchange rate more flexible. Dynamic management and adjustment on the fluctuations of RMB exchange rate were implemented, expanding the daily trading band against the U.S. dollar from 3‰ to 5‰, and the trading band against the euro and yen to 1%-3%. The band against the U.S. dollar in 2012 and 2014 was expanded to 1% and 2% respectively. With increasingly flexible exchange rate, trade in FX market became more active, the market became more effective in discovering price, and exchange rate played a greater role in adjusting import and export as well as capital flows. The continuing trend of RMB’s appreciation prodded China’s trade structure to upgrade and transform, with low-value-added export processing trade decreasing year by year and the international balance of payments improving. Trade surplus in current accounts dropped from 10% in 2007 to 3% in 2015. China’s economy no longer over relies on exports, but is mainly driven by domestic demand and consumption. The fourth round of exchange rate reform has freed the central parity rate from intervention. The Third Plenary Session of the 18th CPC Central Committee highlighted the policy of comprehensively deepening reform which asked for a decisive role of market in resource distribution. To better use the domestic and overseas markets and to better mobilize the resources at home and abroad, so as to improve the operating efficiency of the economy, the RMB change rate must be able to timely and accurately reflect the demand and supply of FX market and play the role of adjusting international payments of balance. In particular, RMB internalization is faster than expected, and RMB is very likely to be included into the SDR basket. The international community wishes china to follow the rule and custom of a floating exchange rate regime. Against this backdrop, on 11 August 2015, the PBoC updated the RMB exchange rate formation mechanism once again and stipulated a market-based central parity rate system in which the market-makers decided the rate with reference to the closing rate in the previous day and changes in the currency basket. To increase the transparency of the process, the China Foreign Exchange Trade System released the CFETS index and RMB exchange-rate index with reference to the Bank for International Settlements (BIS) basket and the SDR basket, to better illustrate the currency formation and the weights of each currency in the basket. China Monetary Policy Report Quarter 1 in 2016 elaborated the updated central parity rate system and clarified how the central parity rate is determined. The central parity rate on day T equals the closing rate on day T-1 plus risk filtration coefficient β× (hidden central parity rate on day T minus the central parity rate on day T-1). In the formula, the closing rate is determined by the market demand and supply, and the hidden central parity rate means the adjustment of RMB/USD exchange rate in a bid to maintain stability of the RMB exchange rate against the currency basket. In cases of abnormality, the central bank can choose different β value to filter the risks induced by over-fluctuations of exchange rate. Market-makers can release the central parity rate with reference to changes in the CFETS basket, the BIS basket and the SDR basket. With this round of reform, the RMB exchange rate fulfilled its marketization goal and a transparent and improved formation system consistent with international standard was established. RMB has been unpegged from the U.S. dollar and began to change with reference to the currency basket. That is, China provided an institutional guarantee which allows the RMB to fluctuate independently from the dollar and other currencies and increases RMB’s role as a major currency in international trade and capital flow and other activities of payments and transactions. 3. Three causes behind the short-term RMB depreciation Under the new exchange rate system, the exchange rate will be determined by the market supply and demand and will be free from the interventions from the central bank, unless there occur any abrupt or unusual incidents, say, international financial crisis, natural disasters or large-scale speculation impact and other incidents that might threaten China’s economic and financial security. According to the exchange rate formation principles and empirical studies, short-term exchange rate has a special formation mechanism, usually irrelevant with the economic fundamentals, but is determined by information channels, capital movements in the short term and market expectations, among which the direction and scale of capital flows are the most deciding factors. In 2016, international financial market has experienced a string of accidents which escalated capital movements and brought volatilities to the FX market. Many countries of the G20 saw their currencies fluctuate in a wide margin, with exchange rate changes exceeding 3% of the daily trading band and some currencies rising or dropping by more than 10%. On Oct. 2016, RMB dropped by 1.28% against the U.S. dollar; the euro, Japanese yen and British pound depreciated by 2.05%, 3.02% and 4.67% respectively vis-à-vis the U.S. dollar; the Russian ruble, Singapore dollar, South Korean won, Turkish lira depreciated by 1.75%, 1.87%, 3.74% and 2.43% respectively vis-à-vis the U.S. dollar. Though RMB depreciated in general this year and fluctuated in a wider margin than before, it still remains to be the most stable currency compared with other major currencies and currencies in other emerging markets. Objectively, RMB’s depreciation is an inevitable outcome resulted from three factors. First, international balance of payments came to a new phase, and market expectations reversed. Experience showed us that economic structure adjustment can take a long period of time during which economic slowdown is a frequent corollary. At present, China’s economy is still amidst economic structure adjustment and is faced with de-capacity, de-inventory and de-leveraging tasks. Besides, investment and export lost their steam, new drivers are yet to take shape, and pre-existing market expectations propping up the economy now dissolved. In 2015, the situation of dual surplus in both current and capital accounts lasting for more than 20 years in China is changing. The capital accounts experienced a deficit and China becomes a net exporter of capital, China’s ODI in 2015 ranked the third in the world. The changes in international payments of balance and the large expenditure accompanying One Belt One Road initiative changed the FX supply and demand and reversed the market expectations and caused a sell-off of RMB. Second, the RMB follows a new floating exchange rate regime, and currencies in the basket depreciated against the U.S. dollar. The exchange rate reform on August 2015 stipulated that the market-makers will set the RMB central parity rate with reference to the closing rate and changes in the currency basket. Therefore, despite the pressure for RMB to appreciate considering China’s trade surplus with the U.S. and the dollar oversupply in the FX market, as long as the weighty currencies in the CFETS basket depreciate against the U.S. dollar and depress the RMB index which is calculated based on the basket, the central parity rate of RMB will depreciate against the U.S. dollar as well. Since Brexit happened last February, uncertainties amounted in the UK market and the British pound plummeted to a record low since 1985. In particular, after Britain announced on June its decision to trigger Article 50 on March 2017, the market forecast indicated that the UK economy in Q3 2016 will suffer a hard hit and the British pound is very likely to see a further drop. Financial institutions in London, the largest international finance center with the utmost capital-mobilizing power in the world, embrace the U.S. dollar as a haven asset, making the British pound more sluggish. The Brexit event, triggered by the European refugee crisis and the EU refugee policies, and has exacerbated the situation. What’s more, the prospects on European market get even gloomier with fear that Brexit could lead to a domino effect, attracting Italy to follow suits. The euro was sold off, and capital flooded into the U.S., lifting the U.S. dollar index to a new high since 2008. The U.S. economy seems to be resilient, as shown by economic indicators. The Fed is expected to raise the interest rate within this year. Emerging countries saw capital flight with arbitrages and speculations, and depreciations of the ruble, the Ringgit and the lira. Under the impact of the declining index of the CFETS RMB index, RMB also shows signs of depreciation. Third, self-correction of the previous distorted exchange rate and technical adjustment. Since 2005, the interest rate of RMB remains higher than that of the U.S. dollar, with a 3%-5% spread. According to the interest rate parity, RMB is supposed to have depreciated against the U.S. dollar by 3%-5%. However, China’s capital control constraints the free flow of short-term capital, and thus stems the arbitraging capital. In addition, with the RMB becoming the haven asset in the financial crisis and with RMB internalization process gaining steam, RMB didn't depreciate, instead, it kept appreciating at a slight pace year by year, accumulatively up by 20% in the last decade. Benefitting gains from the interest spread plus profits from the RMB appreciation, international investors received a favorable 8% rate of return, as a result, more and more arbitrage capital flooded in China. After China opened up the capital accounts in Free Trade Zones (FTZs), RMB can be used more freely than ever. In particular, since the improvement of exchange rate formation mechanism in 2015, the distorted exchange rate was corrected and the free lunch era was ended, meaning that investors can no longer expect to get risk-free benefits. After a long-term appreciation, RMB exchange rate is in need of technical adjustment to return to a reasonable level consistent with the interest rate parity theory. Such adjustment to some extent increased the expectation of RMB’s depreciation, inducing speculators to jump on the bandwagon to convert RMB to foreign currencies for a quick buck. After one year for the depressing pressure to be dissolved, there is no basis for RMB to further depreciate. 4. The back-up force for RMB remains strong. In theory, short-term exchange rate is always converging toward the long-term rate trend; deviation, if any, won’t last long. The long-term exchange rate in turn depends on purchasing power, or economic fundamentals. Countries with robust economic growth usually saw a concomitant of strong currencies with higher purchasing power and long term appreciation trend. Despite the fact that the CFETS RMB index dropped by 6.5% as of October this year, indicators of the macro-economy are in line with expectation and the economic fundamentals remain in good shape, therefore, the basis backing up RMB remains sound and solid. First, China’s economy fares well so far, steadily increasing the purchasing power of RMB. At the critical juncture of economic transformation and structural reform, China takes decisive measures in optimizing the resource allocation, encouraging innovation and technology development, nurturing green industries and strategic emerging industries. By boosting consumption and increasing the investment efficiency, China maintained a medium-to-high growth rate. The growth rate of the previous three quarters in China is 6.7%, outperforming other G7 countries at the same period in which the U.S. enjoyed a 2.5% growth and the UK 2.1%. For emerging markets and economies, the growth rate is 4.3%.The IMF raised its 2017 growth forecast for China which still maintains prominent advantages compared with other developed countries and emerging markets and economies. Second, China has improved its trade structure and maintained a steady surplus. The balance of payments in current accounts is the determining factor of long-term exchange rate. Usually, countries with trade surplus face the pressure of currency appreciation whereas countries with trade deficits are very likely to witness currency depreciation. With demographic dividends and cheap labor, China has maintained large trade surplus since 1994 when it opened up the currents accounts, with the export exceeding the import for so long a time. China even surpassed Germany and became the largest exporter in 2014. In the global context of economic slowdown and trade contraction, the U.S. and Japan saw a trade deficit in the first three quarters in 2016, whereas China’s export-import value reached 17.53 trillion yuan. Though the number is 1.9% lower compared to the same period last year, the import saw a drop even further, which made for a 10% increase in trade surplus. What’s more, China’s competitiveness increased. High-value-added trade is increasing in share, amounting to 56% of the total trade in the first three quarters in 2016, a strong signal that China no longer serves as the cheap labor factory in the international trade chain. With the One Belt One Road initiative forging ahead, China has a broad prospect in international capacity cooperation. Industries such as high-speed railways, electricity, telecommunication and infrastructure embrace tremendous opportunities; direct investments in countries along the belt and the road are in a rapid increase; trade led by Chinese transnational enterprises are gaining speed; the business mind and negotiating capacities of Chinese companies are improving. With these, China is shifting from a big trader to a great one. As long as China maintains the surplus in current accounts, and the capital outflows is lower than the surplus volume, the FX supply will exceed the FX demand in general, giving impetus for RMB to pick up. Third, China is playing an increasingly prominent role in global governance, due to its rising economic strength and soft power. To mobilize the resources at home and abroad and to better utilize the home market and the foreign market, China broadened the scale of opening up. Leading by the success of FTZs in Shanghai, Guangdong, Tianjin, Fujian, China added another 7 FTZs on September 2016, exploring generally applicable practices and aligning the FTZs with international trade standard in modern manufacturing, hi-tech, commodity trade, logistics and cultural communication. In doing so, China actively participates in the making international rule that promotes global trade. At the G20 summit in Hangzhou, the participating leaders fully recognized the significance of infrastructure construction and the supply-side structural reform, and speak highly of Chinese practice and Chinese wisdom in boosting global economy. After One Belt One Road gained wide acceptance by the international community, China gained more say in global governance and global trade. The rising economic soft power strengthened China’s international influence and intangible asset, and also provided political endorsement for a strong RMB. Fourth, RMB becomes a major international currency, giving motives for foreign institutional investors to increase their RMB holdings. To increase the supply of public goods, and expedite the use of RMB, Chinese government has done tremendous work. In 2015, The first phase of Cross-border Interbank Payment System (CIPS) come into service, providing technical support for an efficient, convenient and safe settlement and payment of RMB, giving initial shape to the treasury yield curve and offering a price-setting benchmark for treasury trade, and promoting infrastructure for the internalization of RMB bond market. The exchange rate formation mechanism was also improved, enabling the rate-setting process to be in line with international practices and become more transparent, which is favorable for a reasonable market expectation and also favorable for the purchase and sale of RMB assets. After RMB’s inclusion into the SDR, the State Administration of Foreign Exchange (SAFE) released a bundle of measures to expedite the two-way flows of capital. Measures include: loosen the restrictions on FX settlement under capital accounts, allowing enterprises to settle FX for businesses; give enterprises more flexibility in borrowing foreign loans, streamlining the case-by-case verification to balance management; ease the access for foreign institutions to China’s inter-bank FX market, inter-bank lending and bond markets, without threshold of trade volume. An open capital market set the precondition for the international community to increase holdings of RMB assets, and the high rate of return of RMB asset gave even more incentives for the international community to increase their RMB holdings. At present, the ECB and Japanese central bank adopt negative interest rate. Although the Fed raised the interest rate whereas PBoC decreased the reserve requirement ratio (RRR) and the interest rate for many times, the interest rate of long-term RMB treasury securities is still 1.5% higher than that of the U.S. dollar. The appeal of the highest rate of return of RMB among the SDR basket currencies further boosted the allure of currency. Another incentive for investors is China’s high sovereign rating compared with other emerging markets and economies, meaning investment in RMB is at lower risks. Therefore, from a long-term perspective, investing in RMB assets is a good choice by all measure. RMB assets are gaining popularity among international investors whose further investment will add capital inflows to China and propel RMB to appreciate. The determining factors of short-term exchange rate fluctuations vary from those of long-term fluctuations. The former is determined by capital flows and spillovers from policies of other countries whereas the latter depends on economic fundamentals. In view of China’s robust growth and trade surplus, the likelihood of RMB’s long-term appreciation is strong, and short-term exchange rates will be converging toward the robust long-term trend under the influence of market forces. Short-term fluctuations of the exchange rate can intensify the coupling effects of prices and contagion of risks in the FX market, currency market and capital market, but has little impact on export and import, and capital flows and other activities in real economy. Chinese government needs to maintain a balance in its monetary, financial and distributional polices, make better use of technical policy tools and keep the long-term exchange rate within a reasonable range. Once there is speculative impact, decisive intervention and capital control should be implemented on time, so as to maintain the stability of RMB exchange rate and fend off the systematic financial risks.

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Tu Yonghong: Perspectives on the RMB Depreciation under the New Exchange Rate Formation Mechanism

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