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Managing Depreciation Expectations
The stability of China's currency is dependent on a number of factors
By Sun Jie | NO. 50 DECEMBER 15, 2016

For the last two years the renminbi has been plagued by depreciation pressure. It has, once again, become a hot topic since October. Although the renminbi's depreciation has not roused market panic, the instability of the current international political and economic environment signals the need for caution when dealing with the depreciation.

If anticipation over the yuan's depreciation is becoming increasingly irrational, it means there is much room for improvement in terms of the central bank's communication with the market. To this end, managing depreciation expectations is a key factor in stabilizing the broader economy.

New policy timing

Early in 2014, the yuan's exchange rate dropped slightly after long-term appreciation caused more and more speculative activity. The slight drop led to the outflow of speculative money, and the purchase of overseas assets by Chinese residents and companies further intensified the outflow of money under the capital account. This slight depreciation then changed market expectations on the yuan's exchange rate and even caused short selling of the renminbi in 2015. Under such circumstances, China reformed the yuan's exchange rate formation system on August 11, 2015.

According to the reform, each day's opening central parity rate would be based on the inter-bank foreign exchange market's closing rate from the previous day, and larger fluctuations of the yuan's exchange rate are allowed. This aims to make the yuan's exchange rate formation system more market-oriented and flexible, but under the market circumstances at that time, this policy was interpreted as a signal that the central bank would abandon the goal of maintaining exchange rate stability and would therefore allow the renminbi to depreciate all the time. As a result, the currency depreciated sharply.

The August 11 exchange reform was designed to allow the yuan to fluctuate more freely on the basis of the equilibrium exchange rate and through a market-based exchange rate formation system. It also aims to prevent depreciation from occurring too rapidly and to mitigate significant fluctuations in order to maintain financial stability.

To achieve these goals, the regulatory authorities should have been well prepared, with enough precautions being taken to prevent excessive speculation at any time through effective capital control. In addition, a proper time should have been chosen to launch the reform—when the market is under stable conditions—in order to prevent substantial fluctuations caused by misunderstandings in the market.

Unfortunately, in retrospect, the August 11 exchange rate reform shows that neither the market nor the government was well prepared to meet this challenge.

Throughout the reform, the central bank was criticized for not having enough communication with the market. Nonetheless, the central bank did not stop the pace of its reforms.

After the market stabilized, a new rule was issued in May 2016 to determine the yuan's central parity rate based on previous closing rates and the movements of a basket of currencies. In addition to a more market-based exchange rate, the central bank has also realized its goal of stabilizing market expectations with an exchange rate based on a basket of currencies, strict measures to restrict capital outflow, and less market intervention.

The yuan is stable

More than a year ago, with rapid economic growth and progress made in yuan internationalization, demand for the currency was increasing, resulting in currency appreciation, which further pushed up demand in the market.

This appreciation anticipation reached its peak in November 2015, when the International Monetary Fund (IMF) announced its decision to include the renminbi in its special drawing rights (SDR) basket of currencies.

Since then, the situation has reversed, for a number of reasons. To begin with, amid sluggish growth in the EU and Japan and strong growth in the United States, the U.S. dollar became stronger against other major world currencies. Furthermore, as China's foreign exchange market and the exchange rate formation system became more market-oriented, market fluctuations will have a greater impact on the yuan's exchange rate. In addition, frequent occurrence of "black swan" events in the international

financial market this year made the market more vulnerable to fluctuations. As a result, the yuan started to depreciate.

Market expectations of an interest rate hike by the U.S. Federal Reserve have become stronger, and U.S. President-elect Donald Trump's expansionary fiscal policy will also push up benchmark interest rates in the United States. All of these factors will result in a stronger dollar.

On the other hand, China is facing arduous tasks in terms of economic restructuring, leaving little hope for the Chinese economy to resume the high growth it witnessed in the past. Moreover, the yuan's previous robust appreciation needs to be corrected appropriately. Hence, the yuan is now depreciating against the dollar.

As a matter of fact, almost all currencies are depreciating against the dollar, and the renminbi is just one of them. It's just a natural consequence of a possible rate hike, rather than the result of problems in the Chinese economy.

However, the value of the yuan is not entirely determined by its exchange rate against the dollar. Although the United States is an important trading partner with China, in terms of trade volume, it has already been replaced by the European Union as China's largest trading partner. China's trade with Japan and other emerging economies has accounted for a considerable proportion of the country's total trade. Therefore, yuan exchange rates against the euro, Japanese yen and the currencies of other major emerging markets should also be taken into consideration when assessing the current yuan fluctuation.

Addressing potential risks

Although the depreciation is not serious, it must be addressed with care. Due to a growing amount of risk and instability in the global politico-economic arena, the government must have room to maneuver and address any potential risks.

At present, countries around the world operate conflicting monetary policies. Against this backdrop, a strong dollar will inevitably cause capital outflows in other countries and turmoil in the international financial markets. The currencies of countries suffering from capital outflow will depreciate and their balance sheets will worsen, ultimately leading to financial crises. Such circumstances have occurred over and over in the past two decades and have fueled speculation amongst economists seeking to know when the next financial crisis will break out.

Under such circumstances, the key to ensuring China's economic stability lies in appropriately managing expectations about renminbi depreciation, which have been running rampant in the market over the past year.

China should choose the right time to issue new policies, control the pace of the country's reform and opening up, and guard against any potential risks. These measures should be taken to increase government credibility as well as to prevent misunderstandings in the market's assessment of future policies.

Copyedited by Bryan Michael Galvan

Comments to zhouxiaoyan@bjreview.com

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