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Making Sense of the Yuan Devaluation

August 14, 2015

Is the yuan devaluation the start of a currency war, or a reflection of Beijing’s plan to give the market more power?

It has been a historic week for the Renminbi (RMB or yuan)—following anemic exports data over the weekend, the Chinese currency depreciated almost 2% on Tuesday to touch 6.4491 against the US dollar, the sharpest single-day drop in about two decades, according to The Wall Street Journal. On Wednesday, the RMB fell another 1.6% to the lowest point since August 2011, Bloomberg’s data shows.

Many experts and observers believe that the depreciation is clearly a means for the Chinese government to support exports and thus prevent further economic slowdown; but others suggest that the drop in the RMB’s value is a reflection of the market demand and the Chinese central bank has made a move in the right direction. “I don’t think it is a coincidence that this move follows immediately on the heels of a sharp 8.3% year-on-year decline in Chinese exports in July reported just two days ago,” says Stephen Roach, a senior fellow at Yale University’s Jackson Institute for Global Affairs and former Chairman of Morgan Stanley Asia. “This shift underscores a deepening sense of concern by Chinese authorities over the state of the economy. In some sense, the concern is higher today than at other points of stress,” Roach adds, highlighting that in previous crises, Beijing had always supported the value of the RMB.

Not everyone agrees. Arthur Kroeber, Managing Director at Gavekal Dragonomics, wrote in a research note that the sensitive timing of the currency move has triggered wrong interpretations that Beijing is abandoning reforms and turning back to the tested old trick of boosting exports to support the economy, according to the Washington Post. The move is actually a positive development in the long term, he wrote, because the market is given a bigger role in deciding the exchange rates of the RMB.

Nicolas Lardy, Senior Fellow at the Peterson Institute for International Economics (PIIE) and a respected China expert, has similar views. In a PIIE blog published on Tuesday, he wrote that PBOC’s effort is “far from being a step to manipulate its currency”. Instead, the action is “an effort to let the RMB fluctuate according to the dynamics of the exchange markets,” he added.

But some key questions remain about how much power the market has under the new scheme. Since the reform in 2005, People’s Bank of China (PBOC), the country’s central bank, has been publishing a parity RMB exchange rate daily and traders can only trade the currency within a narrow range above or below that rate. The trading band has been widened several times in the past decade, from the initial 0.3% to the current 2%. What has changed since Tuesday is not whether PBOC will set that mid-point for the market anymore, but how the bank will come up with that rate.

According to PBOC’s statement, the bank is now relying on bid prices collected from market makers, both domestic and foreign, to decide what the parity rate is. Yi Gang, Vice Governor of the bank, told the press on Thursday that between 10 and 20 banks are involved in the process, and the scheme is “transparent and fair”.

“[The process] is like how judges grade divers—we get rid of the highest and lowest prices, the weighted average of the rest is the rate we publish everyday,” Yi said.

And it appears, at least so far, that the statement is true: throughout the week, the parity rate has been set close to the closing price of the currency on the previous trading day; on Friday the rate (against the US dollar) stood at 6.3975, slightly higher than the closing price of 6.3845 on Thursday.

The policy change is in contrast with PBOC actions in previous months, when the bank published steady guidance rates far lower than market realities, effectively preventing the currency to significantly devalue. Some analysts suggest that the change of stance is a result of Beijing’s effort to meet the flexibility requirements of the International Monetary Fund (IMF), which is considering including the RMB in its Special Drawing Rights (SDR) basket, a major milestone for the currency if approved. But on the other hand, Beijing doesn’t want to see the RMB to nosedive neither, as it may cause large capital flight and trigger more repercussions in the economy.

This means that although PBOC is letting market forces have a bigger say, it may still intervene in the currency markets if things go awry. In fact, there were media reports on Wednesday that the bank shored up the RMB in the open market and asked banks to limit dollar selling in order to ease the RMB’s fall. When asked by reporters on Thursday if PBOC did engage, Yi Gang answered equivocally, saying that the bank had ceased “regular intervention” for a long time, and the only acknowledged rule of the game in the market is the 2% trading band that the bank has set up.

But interventions are not necessarily all bad, according to some experts. During an exchange with CKGSB Knowledge on Twitter, Patrick Chovanec, Chief Strategist at Silvercrest Asset Management and an Adjunct Professor at the School of International and Public Affairs at Columbia University, said that he believes that it’s necessary for the PBOC to support the RMB by unloading its large foreign exchange reserve, the excessiveness of which resulted from interventions by PBOC in previous years to keep China’s currency low.

“Imagine if you bought up half the grain harvest and withheld it, then called the resulting price the ‘market price’,” Chovanec wrote. “The real market price, undistorted by your intervention, only becomes apparent when you put that grain back on the market.”

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