China s turbulent weeks:

ThinkChina.dk Policy Brief (No 1 26 August 2015) China s turbulent weeks: How should the 11-August-decision on the Renminbi 1 be interpreted? Clemens Stubbe Østergaard analyses the circumstances surrounding the 11-August-decision on the exchange rate of the Chinese Renminbi. Main conclusions Surface phenomena must not block the perception of healthy fundamentals in China's economy during its difficult transition; The change in currency regime aims at inclusion in IMF's basket of top-five SDR currencies; Denmark and the EU should applaud China's work to internationalise its currency. An overreaction and its causes On 11 August 2015, China changed its currency regime, resulting in a 3-4% depreciation of the RMB. Today, two weeks later, how shall we assess this move? The picture that presents itself is muddied by the large overreaction in global stock markets during the latest week. A generous interpretation of this overreaction would point to a number of causes related to China: The new normal for China s economy, as announced by the Chinese leadership, entails a lower GDP growth rate, to enable reform-implementation, among other things. No more double-digit growth rates. China s stock market corrections. After fairly irresponsible rises, encouraged by the government, and aided by leverage, a number of clumsy interventions have raised questions regarding the Chinese state s ability to handle market forces. The correction itself is quite justified, a brief bubble had arisen. China s slight devaluation in connection with the sudden move to a new exchange rate system, frightened investors. A fall in China s July export figures of 8.3% compared to last July. Unfounded fears around a housing market crash in China these fears have been around for 15 years. Announcement of a low PMI (Purchasing Managers Index) for July, at 47.8 the lowest in 77 months. 1 China s currency is officially called the Renminbi, or RMB. The Yuan is the unit of account. 1

It can be argued that these are fairly superficial phenomena, while fundamentals in the Chinese economy are still quite good and untouched by the above. This has also been the general perception among academics and bank economists at recent meetings in the ThinkChina Working Group on Economics and Business 2. The economy is not in as bad shape as some global investors imagine, regardless whether their misperception is based on ignorance or misguidance 3. To counter the above points, consider the following: GDP is still strong at 6.5-7%. It is a slow-down, not a hard landing. The stock market does not have much to do with the real economy in China. It is small, involves only about 8-10% of urban population, and investors have many other kinds of assets. It is still up compared to a year ago. The government seems to have stopped intervening, giving up fighting gravity in the equity market after spending around $200 bn. However, a small interest rate cut, and reduced reserve ratio requirement was introduced the day after Black Monday, 24 August 2015. The devaluation at about 3% has only a negligible effect on the economy. It was misinterpreted (as I shall discuss below). China s growth rate has never been primarily dependent on net exports. Only for a few years, 2005-7, did they contribute a few percent to the growth rate of GDP. The problem now is low demand in main markets, Europe and Japan, not in prices. Housing prices are already bouncing back in the big cities. Ghost towns have been shown to be an exaggerated phenomenon. There is still a need for correction of the market in certain cities however. The property overhang in second and third tier cities will take some years to work off. The low PMI for July was affected by the EU s then unsolved problems with the Greek crisis. If we look at consumer demand it is up 10.5% this year, and real wages are still rising. The service sector is doing very well indeed, meaning employment is fairly safe. Let us take a closer look at one of these factors, the change in the exchange rate system announced on 11 August, accompanied by a one-off 1.9% devaluation of the RMB. To be fair, this move spooked the global markets. Over the last 10 years, China has been the bulwark absorbing all the knocks of the world economy with its real economy, and not by changing its currency regime. All other large economies in the world used the exchange rate to stimulate their economies, through various quantitative easing programmes. Now the only safe bastion seemed to disappear, uncertainty reigned. 2 ThinkChina.dk is University of Copenhagen s think-tank on China. Recent roundtable meetings in the ThinkChina Working Group for Economics and Business include Game of balancing: the AIIB and Chinese stock market turmoil and its consequences for the world economy. For more information see thinkchina.ku.dk. 3 See, e.g. interview with David Dollar, former World Bank Chief China, in Nikkei Asian Review 14 August 2015. 2

Possible reasons for the 11 August currency change A bit of history: From 1994 to 2005 the RMB was pegged closely to the dollar. Then it was in a soft peg to the USD, a managed float, for the next ten years, allowing it to appreciate by 25-30% against the dollar. Recently it followed the USD up, appreciating nearly 20% against the euro just over the last year. What happened two weeks ago was this: the daily central parity for the exchange rate, announced by the PBOC would now be based on the closing price of the previous day, as reported by 10-20 big banks or market makers. It would then be allowed during the day to move within a band of +/- 2%. The width of the band is one possible variable that can be changed, in the past it has broadened from a start at 0.3%. What are the possible reasons for the change on 11 August? And what is the most likely reason? It is quite important how the change is viewed, because if it is seen as primarily a devaluation followed by an open-ended depreciation process, then it promotes investors concern that the Chinese economy may be weaker than imagined, and weaker than it actually is. First of all, the move can be seen as yet another incremental step towards full market control over the currency, closing the gap between central parity and global market rates, sometimes called offshore rates. Letting market factors play a bigger role, intervention would be limited to special circumstances, and perhaps be coordinated with other countries via currency swaps. This is the official standpoint. But intervention in the currency market has been common during the last two weeks, as government traders on the PBOC s open market desk intervene in the last hour of trading to buy Renminbi and sell dollars for about $10 bn. a day. So far $200 bn. have been spent, possibly also some in offshore markets, successfully preventing too much depreciation. Secondly, almost as a knee-jerk reflex, many outside observers have pointed to an export motive. Denied by the central bank, it does seem a bit unlikely that improving the competitiveness of exports is the reason. The depreciation is too small to matter; it would have to be 10-15% to take effect. Massive quantitative easing and subsequently falling currencies, in the two important markets Europe and Japan, have strained some Chinese exporters with traditionally very thin profit margins. But the real problem is low demand in the two markets, and in any case Chinese export businesses have moved up the technology ladder to sell high-end products, which are less sensitive to exchange rate fluctuation because they rely on global supply chains. What is more, the state and its enterprises is a net importer, while the private sector is the net exporter in China, making it even less likely that exports were the driver for this move. There are also damaging effects domestically, such as corporations with dollar-denominated loans bearing a heavier burden. Thirdly, stemming capital outflows could be a reason. They have been growing since mid-2014, and overseas transfers do become less attractive with devaluation raising their cost. But this is a long-term trend, not one that is sudden or has been particularly noticeable right now. China still 3

has strict capital controls that limit the abilities of short term funds to slosh in and out of the country. But China s direct foreign investments and other financial outflows have increased so much that there is a deficit on the financial account, the country is not immune from capital outflows, legal and illegal. Yuan internationalization opens new loopholes for funds to move across the border under the guise of trade settlement. Remember that 25% of China s foreign trade is now settled in Yuan. The final reason could be related to the fact that this year the IMF is in the process of deciding whether the RMB should be included, with dollar, pound, euro and yen, in the currency basket on which the IMF s own currency, the SDR 4, is based. To be included in the SDR, a country must be a leading exporter and have a freely usable currency. Let us look more closely at this explanation for the 11 August move. China's goal is to meet IMF demands on the road to RMB internationalization In a 64-page report on China and the SDR published just a week before the change of system, the IMF said: A market-based representative RMB rate in terms of the US dollar would be needed to value the RMB against the SDR. The representative rate is currently the onshore fixing rate, i.e. the central parity rate, announced daily by the CFETS at 9.15 a.m. However, this rate is not based on actual market trades, and can deviate by up to 2% from the onshore market exchange rate. In the event of SDR inclusion, the Fund, in consultation with the Chinese authorities, would need to identify a market-based exchange rate that could be used as a representative rate for the RMB. Based on the staff s preliminary assessment, it appears that one of the benchmark rates already calculated daily by the China Foreign Exchange Trading System (CFETS) would be suitable for this purpose. I will argue that the change is indeed part of the reforms set out in the Party s so-called Sixty Point reform-program of November 2013. Building on the previous 35 years of reform, it has 2020 as its deadline. Its section 12 covers financial liberalization, and some progress has been made: private banks permitted to open, foreign banks to enter, interest rate liberalization has progressed, as has limited capital account opening. But perfecting mechanisms for the formation of Renminbi exchange marketization [ ] accelerating the realization of the convertibility of Renminbi capital accounts, as means of internationalizing the Renminbi, may now be coming into focus. Why is getting into the SDR basket important for realizing the larger goal of internationalization of the Yuan? The SDR is not important in itself, it is rarely used, but it is a necessary step on the way to becoming a reserve currency, because of the status and trust it confers on the Renminbi. It is a 4 The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. In addition to its role as a supplementary reserve asset, the SDR serves as the unit of account of the IMF and some other international organizations. Source: Wikipedia 4

global recognition of a rise in status, but also makes it easier to denominate trade in yuan so avoiding risky exchange rate fluctuations. And why does China want the RMB to become a reserve currency? The Wall Street crisis was a shock for China. They had some faith in the American financial system, but suddenly it was very turbulent to be inside the dollar-zone, as one is when most of one s trade is denominated in dollar. It means being dependent on another country s monetary policy, and dependence is not something Beijing cherishes. Being a reserve currency also gives some advantages, such as cheaper loans, the possibility of turning Shanghai into a real global financial centre, all central banks holding your currency, etc. It may also seem a natural development for a country which is the biggest manufacturer, the biggest trading nation and one of the world s two biggest economies. So, from about 2009 it was a clear Chinese policy to internationalize the RMB, to open capital markets, to make Shanghai a new Wall Street or City of London. With a global capital market on its territory, talent can be attracted worldwide and capital for large projects like the Belt and Road Initiative becomes easier to get. An internationally respected currency is sine qua non for this strategy. This year the IMF, as part of its 5-yearly round of evaluating the SDR-basket, has been evaluating China. IMF staff has been producing reports, in dialogue with Chinese experts and authorities. IMF-chief Christine Lagarde has said that including China is not a question of whether, but of when. With the clock ticking down to a decision in November this year, China has been listening closely to the IMF; it does not want to wait another five years. The IMF spokesperson quickly praised the 11 August move, as did the US Treasury more cautiously. There are no metrics for the freely usable criterion, it is a judgement call, and as Japan s inclusion showed, full convertibility on the capital account is not a must. The IMF said: The new mechanism for determining the central parity of the yuan announced by China s central bank appears a welcome step as it should allow market forces to have a greater role in determining the exchange rate. Greater exchange rate flexibility is important for China as it strives to give market forces a decisive role in the economy and is rapidly integrating into global financial markets. Probably because of this year s turbulence in China s markets, and the need for other reforms than the one now implemented, the IMF then decided that if it opts to include RMB the move will not take effect until September 2016. This looks like an SDR-inclusion in principle, on the expectation of some further reform moves over the coming year. For the IMF this is not entirely a question of objective criteria. Political considerations must enter, particularly after the spectacle of the US Congress blocking China s representation in another Bretton-Woods organization, the World Bank. That led to China establishing several new development banks that could easily come to rival the World Bank. The move does not seem to have led to a currency war in the region. With global overreaction to China s problems, many of the currencies of the region s countries, most of which are dependent 5

on China s economy, have automatically been weakened even more than they already were, obviating the need for formal devaluations, with the exception of Vietnam. American reaction varies: experts and analysts see that the move is in the direction that the US wants China to go, while Congress-members and presidential candidates abuse it for the sake of domestic politics. European, including Danish, reaction has been sparse, but ought to applaud the move towards further role for the market. The method is typical for Chinese reform: gradual advance towards full convertibility, keeping the possibility of moving back a pace, in case of danger. This means that intervention can be gradually reduced, the band gradually widened, until in two or three years time the exchange rate is fully market determined. It is a learning process for China, handling markets is not easy, including the psychological aspects, and China still lacks many of the institutions we take for granted in a mixed economy. The state maintains an important macro-economic leadership role learning as it goes and like Denmark they will have to defend their turf against international currency speculation, probably already weighing up the possibilities of an attack. But a weaker economy, a share price crash and looser monetary policy this year probably all justify a slightly weaker Renminbi, as we now have it. Ironically, the real effective exchange rate is actually strengthened because other countries currencies have weakened more. Clemens Stubbe Østergaard is Senior Research Fellow at NIAS-Nordic Institute for Asian Studies & member of the ThinkChina Working Group on Economics and Business. Disclaimer: The views and opinions expressed in this ThinkChina Policy Brief are those of the author(s) and not necessarily those of ThinkChina.dk. Comments and contact Martin Bech - ThinkChina Coordinator Phone: +45 2962 3147 Mail: martin.bech@hum.ku.dk ThinkChina.dk University of Copenhagen 6