China’s New Exchange Rate Policy
Concerted appreciation is out. From now on the Chinese yuan will shadow the broad US dollar. On our forecasts the new policy implies the yuan will depreciate against the US dollar over the next year.
China’s central bank, the People’s Bank of China (PBOC) depreciated the Chinese yuan (CNY) in May, only the third month it has done so since June 2010 when the managed float policy was restored. The exchange rate depreciation coincided with the release of data indicating a drop in foreign reserves in April. The net effect was to reinforce fears that China was on a slippery slope to a hard landing via an overvalued currency and capital flight.
Prolonged reserve losses and a depreciating currency are sure signs that the exchange rate is over-valued. However, occasional depreciations or reserve outflows need not be. We think the changes in China were one-offs, not chronic conditions.
One-off depreciations and foreign reserve outflows are consistent with an exchange rate policy of having the local currency’s exchange value against the US dollar “shadow” the broad US dollar. Such a policy is followed by many of the PBOC’s Asian counterparts. They appreciate the local currency against the US dollar when the US dollar depreciates against major currencies and vice versa. The “shadowing” policy damps fluctuations in the competitiveness of Asian currencies.
The policy of shadowing the broad US dollar implies a tight relation between the broad US dollar and the local currency’s exchange value against the US dollar. Statistical analysis confirms this. Central bank reaction functions measuring the percentage change in the local currency’s exchange value against the US dollar for a one percent appreciation in the broad US dollar for Korea, Malaysia, Singapore, Taiwan and Thailand, all of whose currencies are considered undervalued by the IMF (Taiwan is not an IMF member but we think the Taiwan dollar would be undervalued on the IMF’s metrics), range from -0.7 for Taiwan to -1 for Singapore and average -0.8.
The CNY also is considered undervalued by the IMF, which makes the PBOC a natural candidate to adopt the shadowing policy of the other five central banks. We believe Chinese Premier Wen Jiabao’s March pronouncement that the CNY was “near equilibrium value” did just that.
PM Wen’s pronouncement signals an abrupt change in PBOC policy. Concerted appreciation has been replaced by shadowing the broad US dollar. From the adoption of the managed float in July 2005 the authorities pursued a policy of concerted appreciation, interrupted only for the Global Financial Crisis. Shadowing implies that moves in the broad US dollar will play a prominent role in determining the CNY’s exchange value. ING forecasts the US dollar appreciating against major currencies over the next year. Shadowing implies it also will appreciate against the CNY.
We suspect PM Wen’s March pronouncement was linked to the broad US dollar’s strength from the fourth quarter of 2011. Concerted CNY appreciation (against the US dollar) was easier when the US dollar was depreciating against major currencies. Concerted appreciation when the US dollar also is appreciating requires the central bank acquiesce to having the strongest currency in the world, something Asian central banks typically are not comfortable with.
As the firmer US dollar triggered the policy shift from concerted appreciation to shadowing, it also created the conditions for healthy internationalization of the CNY. Internationalization’s first stage, centered on the offshore Chinese yuan market, was driven by speculative demand. Healthy development requires replacing speculative motive with demand based on the CNY’s attraction as a store of value. Greater two-way CNY risk means manifestations of the speculative period like the offshore market and the dim sum bonds face a questionable future. The upside is that it opens the door to capital account liberalization, including interest rate reform.