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China: what are the motivations of the recent depreciation of the RMB?

The decision to change the exchange rate regime of the renminbi taken by the Chinese authorities at the beginning of August might be less a response to the economic downturn than a further step, against all odds, in a bold but risky financial liberalization agenda.
By Christophe Destais
 Post, September 14, 2015

On 11 August, the Chinese central bank (PBOC according to its English acronym), announced a change in the way the daily exchange rate of the currency, the Renminbi (RMB) is fixed. While previously, the PBOC decided in a discretionary manner of the central renminbi/dollar parity around which the transactions could take place in a narrow band of ± 2%, it now takes into account the actual exchange rate at which transactions took place the day before and the market conditions to secure the current daily pivot RMB/USD exchange rate. On 23 July, the Council of State (Government) had announced that the permitted fluctuation band would be widened to ± 3%.
This decision - announced without notice - led to a depreciation of the Chinese currency which the PBOC contained through market interventions (the RMB fell by less than 3% against the dollar). Indeed, international financial markets interpreted negatively the change in the management of the exchange rate as a response to the rapid deterioration of the Chinese economy and the stock market correction.
Interpreted in cyclical terms, the PBOC decision would be justified. The exchange rate of the renminbi followed the nominal appreciation of the dollar vis-a-vis the yen (+ 50% in two years) and the Euro (+ 15% to 20%). It would be logical that the PBOC seeks to give some air to Chinese exporters while growth in domestic demand slows down, probably significantly.
However, it seems that this decision was taken by the Chinese monetary authority, not because of the economy, but rather in spite of it. According to such interpretation, the real motivation was to send a signal of a better consideration of market forces in the determining of the exchange rate. The context was the discussion of the inclusion of the renminbi in the basket of currencies used by the IMF to calculate the value of its unit of account, the "special drawing rights" (SDR). China is negotiating since 2011 on this and a decision was due in the fall of 2015. But an IMF report, published in early August, proposed to postpone the deadline by nine months, disputing that China meets the mandatory criteria of "free use" of its international currency. Indeed, capital controls still exist at China's border though they are being relaxed and the lack of depth of Chinese financial markets still limit the liquidity of RMB-denominated assets held by non-residents.
Thus, the motivation of the PBOC's  decision would be strategic and not economic. It would be a step in the ongoing liberalization of China's financial sector which indeed significantly progressed in recent years. The banks' lending and deposit rates are no longer set by the government. It is easy for Chinese companies to invest  abroad. Chinese banks' external liabilities are on the rise. Under the umbrella expression of "RMB internationalization", numerous steps have been taken to facilitate the use of RMB outside China for billing, payments, but also for financial transactions. Finally, the system of quotas which still frame foreign portfolio investment in China was is being eased and a similar system for Chinese investors overseas was being relaxed until the recent deterioration of the economic situation.

The fast pace of financial liberalization contrasts with that of other reforms that have been announced since the arrival to power of President Xi Jinping in 2012, such as strengthening the role of the market in resource allocation and developing  of the rule of law or the land reform. In these areas, progress has been very slow. Reforms clash with vested interests of exporters, public companies, and some local authorities. The ongoing anti-corruption campaign could help to weaken these interest groups, but its main purpose seems to be much more political control than economic reform.
Pursuing financial liberalization, China's central bank and part of the Chinese authorities would bet on China's financial opening to advance an agenda of internal market reforms.
If we consider only the external monetary and financial balances, such a bet  would be risky. China has indeed managed the transition from a situation in which most of the huge external surpluses were recycled by the central bank in the form of foreign exchange reserves, which peaked at almost 4000 billion, to a situation in which, with the liberalization of capital flows, Chinese assets outside the country are diversifying: a growing share is owned by private Chinese investors, the foreign assets held are less securities issued by governments and government agencies and more investments in various forms in the private sector.
This transition is difficult. A quick redeployment  of foreign reserves to other asset categories could promote adventurous strategies abroad. China could also experiences the difficulties faced by other countries that have liberalized short-term capital flows: inflows and outflows can be brutal, they can have a destabilizing effect on the overall financing of the economy and weigh on the solvency of the companies and the financial institutions that are exposed to international financing. The transition can also be affected by fluctuations in the exchange rate, themselves related to the reorganization of these external  assets and liabilities, the deterioration of China's international competitiveness and the uncertainty about its economy. The likely willingness of the Chinese authorities to mitigate these fluctuations might, in turn, constrain monetary policy.
Emerging Countries  | Money & Finance 
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