China's exchange rate regime makes economic sense

Standard & Poor's looks at the motives behind the PBoC's rate adjustment and reasons that a more flexible exchange rate could help prevent risks to the sovereign credit rating.

China's exchange rate regime makes economic sense
PBoC exchange rate move stirs debate

Why is China changing its currency regime? And why now?
Given the uncertainties around the state of the Chinese economy, which continues to show softness, speculation has abounded as to the People's Bank of China’s (PBoC) motives. These range from a relatively benign "technical correction" aimed at improving market functioning to a more sinister opening of a "currency war" to an effort to comply with IMF conditions to get the yuan included in the special drawing rights (SDR) basket sooner rather than later. We tend to put more weight on the first and third reasons.

Nevertheless, the rationale for the timing of the move isn’t entirely clear. We doubt the popular claim that it was driven by weak July trade data since these have been soft for some time--the trade surplus has been trending at a high level. We also think that it's better not to announce these changes in advance, as this would allow some players, especially "insiders," to illicitly profit from the regime change. We do subscribe to the view that the timing was opportunistic. This is because China can now say that by moving to a more market-determined rate it is delivering what the IMF and US Treasury have been asking for. And since the pressure is now on the yuan to weaken, having more exchange rate flexibility is palatable to the Chinese authorities.

Do the PBOC's recent moves make economic sense?
Yes. From a theoretical perspective, an economy cannot simultaneously have: (1) a fixed exchange rate, (2) an open capital account, and (3) an independent monetary policy (the ability to set interest rates independently from the rest of the world). As the capital account is increasingly liberalised, this trilemma implies that China's ability to enjoy (3) becomes more limited. (Hong Kong has opted for the first two, so it must effectively import US monetary policy). So China allowing for more exchange rate flexibility makes good economic sense. It's not the start of a currency war.

Can the PBoC still intervene in the forex market to manage the level of the yuan?
Of course. In addition to enforcing the band, as necessary, and trying to dampen "excessive" volatility, the PBoC can still intervene to influence the exchange rate. Indeed, this will be more transparent since unlike the old regime, where the fixing rate could deviate from the market rate by fiat (and without using reserves) that is in theory no longer possible under the new system. Movements in the spot rate have to be earned by using reserves.

Was this a move to jump-start exports and growth?
We don't think so. The argument on this side of the Pacific has always been that exports are more a function of foreign demand, with the exchange rate playing a secondary role. (The usual ratios are that exports are driven four-fifths by foreign demand and one-fifth by the exchange rate.) There is no reason for that relationship to have changed. So the argument that China is trying to jump-start growth by weakening its currency to spur exports does not strike us as very convincing, although it is getting a lot of press coverage.

What are the likely effects on trade?
This would depend on a few factors but, again, we expect the effects to be modest. First, the initial 2% devaluation was small, and likely will not "move the dial" in terms of exports. If the currency continues to weaken, the effects will depend on the extent to which a cheaper currency is passed on to final consumers. To take the recent example of the Japanese yen, there has been a substantial deprecation over the past 1.5 years from around 75 to around 125 yen per US. dollar. But most of this has benefited Japanese exporters in terms of higher profits measured in yen rather than higher export volumes stemming from passing on lower US dollar prices to consumers. For other countries, any effects would depend not only on the pass-through noted above, but to what extent their export goods compete with China in third markets. Much of the supply-chain trade comprising intermediate goods traded across Asia is complementary, and China is not a big exporter of commodities, so those types of goods can largely be ruled out. We would look at lower-end electronics and capital goods for third-market effects.

What should we be watching?
Clearly, the new system will have growing pains. We will be watching how the fixing rate relates to the previous close, as well as how the market behaves toward the end of the trading day given the new importance of the "last price." We will also be watching to what extent the PBoC intervenes outside of the required moves to enforce the band. The hedging markets need volatility in order to develop, and the "chicken and egg" issue will not be resolved unless the central bank allows the exchange rate to move. Finally, if there is significant, sustained pressure on the yuan to weaken, we wonder at what level the authorities would step in given the sensitivities that still surround exchange rate valuation in China.

Are there any implications for monetary policy and the sovereign credit rating?
China's move to allow a more flexible trading of the renminbi exchange rate could help maintain the flexibility of the country's monetary policy as cross-border financial flows increase. We believe the increased exchange rate flexibility could also prevent the build-up of risks to the sovereign credit rating (AA-/Stable/A-1+; cnAAA/cnA-1+). The move has a limited immediate impact on credit support. Chinese capital account liberalisation has moved ahead steadily over time. Recent changes have allowed foreign investors greater access to the country's financial markets. Chinese companies have also increased international borrowing as some of them venture abroad. Furthering this trend without greater renminbi exchange rate flexibility could constrain monetary policy and increase the risk to financial stability. The central bank can better set policy to maintain price stability if it does not have to keep the exchange rate in a very narrow range. Chinese borrowers are also likely to become more aware of foreign exchange risks if the exchange rate shows significant fluctuation over time. This could encourage risk hedging and prevent excessive foreign borrowing that could raise financial risks that hurt sovereign credit metrics.

The authors of this article are Paul Gruenwald, Standard & Poor's chief economist for Asia-Pacific, and KimEng Tan, Standard & Poor’s sovereign analyst.

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