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Currency Reform: Float of the RMB

by Tom Nunlist

August 9, 2017

China has attracted much criticism in recent years for how it manages the RMB. It is not a free-floating currency, but in reality, the consequences of China’s currency controls are complex, and the road to achieving a more open currency difficult

On the campaign trail last year, Donald Trump constantly deplored China as a currency cheat. At the core of his accusation was the idea that the country manipulates the value of its currency, the renminbi (RMB), to make exports cheaper and gain market share. If elected President, he promised to officially label the country a “currency manipulator” and put a 45% tariff on imports on his first day in office.

As with so much else during his Presidency so far, Trump later backtracked. On April 12, shortly after a one-on-one meeting with President of China Xi Jinping, he declared that China was not a currency manipulator.

“We have repeated that China has no intention to spur exports through competitive currency devaluation,” said China Foreign Ministry spokesman Lu Kang on April 13th, the day after Trump’s turnaround. “It’s an objective fact that China is not a currency manipulator.”

This is debatable—the RMB is certainly not a free-floating currency—and China’s central bank sets the daily rate with movements allowed only in a narrow 2% band around that rate. “You basically have a market that has one leg tied and one arm tied,” says Fraser Howie, author of the book Red Capitalism and noted commentator on the Chinese economy. “The fact that the volatility is so low makes no sense. This is the world’s second largest economy.”

The Chinese government has talked for decades about liberalizing the RMB and making it convertible on the capital account, but has so far not done it. Meanwhile, it has mounted a campaign to internationalize the currency with considerable success despite its continued controlled status. In October last year, after years of pressure from Beijing, the International Monetary Fund added the RMB to its Special Drawing Rights (SDR) basket, which also includes the US dollar, the Euro, the British pound and the Japanese yen. It was a symbolic victory, but analysts say it has little practical impact, at least in the short-term.

Shortly after it happened, Paul Donovan, the Global Chief Economist of UBS said, “In the longer term, this should be seen as a political ego-stroking exercise.” And in fact, while the RMB was the world’s fifth most used currency in 2015, it slid to sixth place in 2016, being overtaken by the Canadian dollar, which is not in the SDR basket.

Achieving a wider role for the RMB around the world, and getting to the point where the currency can move according to market forces rather than the decisions of Beijing bureaucrats, will require parallel liberalization of the economy. “The reason why the Chinese government should liberalize its currency is to facilitate trade and investment,” says Yang Du, former Director of RMB and China Strategy at Thomson Reuters.

But the pace of such reforms is likely to remain uncertain.

“While there is a lot of rhetoric about the introduction of market mechanisms, I don’t think China… likes what the consequences of those market mechanisms really are,” says George Magnus, former Senior Advisor to UBS and Fellow at the Oxford China Centre. Therefore, instead of significant reforms, “you get a little bit of this trial-and-error stuff.”

Training Wheels

The status of the RMB today, like China’s wider economy, is a legacy of the planned Soviet-style economy in force from 1949 through to the death of Chairman Mao in 1976. Since then, reforms have massively boosted China’s economic strength, its GDP and people’s living standards, but basic state control has remained inviolable and change has generally been gradual, avoiding “shock therapy” measures.

“It has been a trade-off between liberalization and the stability of the whole economy,” says Yang.

At the beginning of the reform period in 1980, the RMB was officially valued at 1.5 to the American dollar. In 1981, to stimulate China’s new export sector, the government devalued the RMB to 2.8, and over the next 15 years or so, China allowed it to drift downwards until it was pegged in 1995 at 8.3 to the dollar, a rate that was maintained for a decade. The dollar peg at that level helped tame economic instability and fueled China’s transformation into the so-called “factory of the world.”

By the mid-2000s, China was still enjoying annual double-digit GDP growth, but the government was facing mounting economic and political pressure, most notably from the United States, to let the value of the RMB appreciate. In July 2005, Beijing relented and revalued the RMB upward by 2.1%, and introduced a “managed float” system, still used today, under which the currency fluctuates in a very narrow range fixed each day by China’s central bank.

The currency peaked in value at around 6.05 to the dollar in January 2014 and then market sentiment turned, largely relating to a sense that China’s fast-growth phase of three decades was ending. After that, the RMB entered a period of steady decline, which the Chinese government sought to control. Pressure built up until there was a shock devaluation of 2% on August 11th, 2015, when China also began setting the daily RMB fix based on the closing value of the previous day’s interbank forex market.

The general view for much of 2016 was that the RMB was inevitably heading below seven to the dollar—a mark nearly broken in January this year. Since then, it has stabilized and risen slightly. “If it breaks seven, it will damage the central reserve… it will damage the GDP further,” says Yang. “It may crash the [domestic] financial system as well.”

Love, Hate, Manipulate

Along with the general turn in market sentiment against the RMB, the years since 2014 have seen the US dollar become more robust. Many analysts see this as a key factor in the weakening of the RMB, with sellers mostly buying US dollar-based assets in return.

“The number one reason is the strengthening of the dollar,” says Shen Jianguang, Chief Asia Economist at Mizuho Securities, a Japanese investment bank. “Against any other major currency the RMB has actually appreciated: against the British pound, against the Euro.”

If controls were lifted, to what rate would the RMB move? This is, of course, unknown, but the assumption of most experts is that it would be lower than today. How to transition the currency through to being directly market-driven is a conundrum, and the effects of such a move, including those on other countries, would be significant.

This is where the irony in Trump’s accusation comes in. Yes, China is meddling with the currency, but in recent times not to suppress the value against the American dollar. Beijing has actually fought fiercely for the past two years to stall the slide of the “redback,” an effort that has contributed to China’s foreign exchange reserves falling $513 billion in 2015, and a further $320 billion last year.

Despite these efforts, the currency hit an eight-year low against the dollar in November 2016, following bullish US sentiment in the wake of Trump’s unexpected victory, before bouncing back slightly this year. In all, China’s currency fell 5% against the dollar in 2016, starting at around 6.5 to the dollar and ending below 6.9.

Efforts to hold the RMB rate steady against the US dollar have had an impact on China’s export sales to all other markets. But Beijing’s money managers have had no choice due to the psychological importance of the greenback rate. “While the authorities have been moving towards a currency basket system, domestically people still think of the exchange rate vis-à-vis the US dollar,” says Andrew Fennell, Director of Sovereigns at ratings agency Fitch in Hong Kong. “The bilateral exchange rate with the US dollar has a big impact on market sentiment.”

The RMB has fallen steadily against the dollar since 2014 while remaining supported.

China’s broad economic slowdown, which is at the heart of the RMB’s weakness, looms large in perceptions, despite continuing high GDP growth numbers being reported by Beijing—6.5% percent for 2016 and 6.9% for the first quarter of this year. “The reality is that the economy is decelerating fast,” says Shen. “I think the official GDP is very distorted.”

This is worrying for wealthy Chinese people, especially the middle class and companies that do cross-border business. For them, the prospect of a fall in property prices is less scary than a fall in the value of the RMB, which would affect the valuation of all assets in China. One businesswoman and homeowner in Shanghai, who asked not to be named, said she fears a devalued RMB more than she fears a bursting housing bubble.

Beijing is caught in a bind—it cannot strengthen the RMB in line with Western urgings because market forces will not allow it. It also cannot let it fall because the masses will not stand for it.

In the view of some analysts, the situation has arisen because the economy of China is built on an outmoded structure. “China has not embraced the market by any means. It has the appearance of a market,” says Howie. “But the currency has never traded anywhere near the 2% band apart from [August 11th, 2015].”

Further falls in the RMB could have all sorts of implications for China—not only economic, but social and political too.

“A significant devaluation from the lens of trade theory would help exporters, but that is not really in line with the broader policy goals of rebalancing the economy towards consumption,” says Fennell. “A devaluation would basically be a transfer of wealth away from the household sector and towards exporters.”

Fear of market forces driving the evaporation of value has already resulted in large capital outflows. China has responded with ever-tightening restrictions to stop the flood.

Underlying Economy

Despite constant political criticism from the West, management of the not-so-free RMB and the sort-of market-driven economy of which it is a part has complicated consequences for the world economy. A stable RMB and stable Chinese economy are not just good for China, but have benefits for the entire world. A declining RMB would boost Chinese exports by making them cheaper, but it would also exacerbate trade tensions and further hurt what remains of manufacturing in other countries.

While Yang from Thomson Reuters believes a major devaluation could crash the Chinese financial system, George Magnus thinks that China could handle a big devaluation, but that its trading partners will have trouble. So if control of the RMB is currently desirable for China and its trading partners, when can the government let go the reins and ride the free market?

It is hard to say because the Chinese market has no experience with anything other than a controlled currency regime. Liberalizing forex policy at this point, says Yang, would be like trying to teach your kid to swim “while pouring more water into the pool.”

There is also the issue of capital flight, which is a puzzling trend given the amazing growth rates that China continues to experience.

“What China needs to do is focus on reforming the economy,” says Howie. “Allow the private sector a greater role, allow households greater returns, stop funding the SOEs and diverting all this money to needless projects.”

Howie and Yang agree that until such structural shifts are implemented, freeing up the RMB is out of the question and, barring some sudden changes, could be a couple of decades away. It is probably harder to make the transition now than it would have been a decade ago, given the slowing economy and a sense of reduced flexibility. Noting how well the economy performed in the 2000s, Howie says, “When things are going well, do the difficult [tasks].”

Trust Trade-off

The ultimate stated goal of China’s RMB policy is internationalization—widespread acceptance by traders—and eventual use as a major reserve currency by other countries. How well China is progressing towards this goal depends on your perspective.

According to analysis by Fitch using data released by the IMF, at the end of 2016, RMB-denominated assets represented just 1.1% of global reserve holdings of central banks. This was higher than the Swiss franc, but well below the other currencies included in the survey.

However, the RMB has progressed reasonably well as a currency in which trade deals are denominated. In 2014, London became the first offshore settlement center for the RMB. It has since been followed by centers in Doha, Frankfurt, Luxemburg, Paris, Singapore and Toronto. These offshore pools enable the RMB, in Yang’s words, to be “freely usable” in trade activities. How much demand there is to accept settlements in RMB is another story, but setting up the international infrastructure to handle it is a significant achievement.

The next step, according to Yang, is to make the RMB “freely investable,” and this is more difficult. There are already ways to invest the RMB, such as RMB-denominated “dim sum bonds.” There is also the CNH, or “offshore RMB,” that is more exposed to market forces, but the CNH is confusing, and according to Yang does little good. Deposits in Hong Kong have fallen by about half since 2014, and Howie says investors were only there in the first place to take temporary advantage of higher interest rates.

More fundamental is the point that making the RMB a currency for investment means having something to invest in—in other words, opening the capital account. There is great international clamor for China to do this, and it has often been a point of political friction with the US and the European Union. Indeed, in March this year, China relaxed rules on foreign investment into domestic bond markets.

“[The government remains] committed to these reforms, although the pace of capital account liberalization has slowed in recent years as a response to the onset of capital outflows in mid-2014. What we now expect over the coming years is an asymmetric opening of the capital account,” says Fennell. “We will probably see further measures making it easier for foreign enterprises to bring capital into China and participate in its domestic capital markets, while restrictions on capital outflows are likely to remain in place.”

Howie is less optimistic, referring to this as “tinkering”—and the tepid response from investors to the bond market initiative seems to support his assessment. In any case, Howie sees fundamentals as being the greater problem. “How would [internationalization] ever happen if you don’t have trust in the underlying marketplace?” he says. “The key thing underpinning all markets is this idea of trust.”

Slow and Steady

Solving underlying market problems, opening up the capital account in such a way that does not create a crisis, and giving the RMB the market freedom that will make it a stable store of value beyond Chinese shores could take either a long time or a real wrenching change. It is already nearly three decades since Chinese officials started talking about capital convertibility being a few years away, so no one is holding their breath.

Analysts are generally optimistic, although few hazard a guess concerning the timeline. “I am still hopeful, especially that something will happen after the 19th Party Congress (to be held in October 2017),” says Shen. “I think maybe they will progress faster regarding financial liberalization and break down the monopolies of SOEs, and that probably will facilitate the use of RMB further.”

There is, however, a large contrast between long-term prospects and the short-term forces that continue to buffet the RMB, precisely because of its controlled status. “For the time being the currency will be very closely managed,” says Magnus. “I don’t think the leadership wants any currency turbulence or market disruption for the foreseeable future.”

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