New Rules of the Game for China’s Renminbi

In the last two months China has executed a decisive change in its policy for managing its currency, the renminbi. Ending an eight-year period of slow but relentless appreciation against the U.S. dollar, the People’s Bank of China (PBOC) engineered a swift devaluation of about 3 percent, and doubled the size of the currency’s daily trading band. These moves took financial markets by surprise and sowed confusion. Was Beijing simply trying to re-ignite export growth by making its currency cheaper? Or was it making a more fundamental shift?

The answer is straightforward. China has taken a huge step towards making its exchange rate more flexible and market determined. In doing so, the authorities have clearly signaled their intention to switch from a monetary policy that mainly targets the exchange rate, to one that mainly targets domestic interest rates. The change in renminbi policy is thus part of a broad and ambitious financial reform strategy, reflecting the agenda laid out last November in the “Decision” published following the Third Plenum of the 18th Party Congress. It is all about improving China’s macroeconomic management, and has little or nothing to do with boosting exports.

Four Phases of China’s Exchange Rate Management

To understand the significance of the new renminbi policy, some background is helpful. The history of China’s exchange rate management can be divided into four phases. In the first, from 1979 to 1994, there was a steady depreciation in order to wean the country off the artificially overvalued exchange rate inherited from the previous period of Communist autarky. During this period Beijing maintained a dual exchange rate system. This consisted of an official rate, still overvalued, but gradually converging toward reality, which essentially applied to the capital account; and a more market based “swap rate” which was available to exporters. The purpose of this arrangement was to enable a competitive (though rudimentary) export economy to develop while still keeping the local price of imported capital goods relatively low, and avoiding the collapse in living standards that a full-on depreciation would have caused.

The second phase was a brief transition period in 1994-1995 when the two exchange rates were combined and the currency was allowed to float more or less freely in order for fair value to be established. In late 1995 the value of the renminbi was fixed at a rate of 8.3 against the U.S. dollar, initiating the third phase—a hard peg against the U.S. dollar—which lasted until July 2005.

It’s important to recall that the first test of this regime was the refusal to devalue in 1998 in the wake of the Asian financial crisis, when the currencies of the countries with whom China was then competing for export orders all fell dramatically. Rather than devaluing to help out exporters, Beijing hardened its peg. This was costly: China’s exports flatlined in 1998, and arguably the relatively strong currency played a role in the deflation that China suffered for the next four years. One reason the government hardened the peg, rather than devaluing, was to establish that China was a dependable player in the world system and that its currency could be relied on as a store of value. The short-term hit to exports was more than offset by the strategic gain in China’s reputation as “responsible stakeholder” and a safe place for foreign direct investment.

The hard peg against a declining U.S. dollar led eventually to a depreciation of the trade-weighted, inflation-adjusted exchange rate (known as the real effective exchange rate, or REER) that contributed to the exploding exports and ballooning trade surpluses of the early 2000s. This in turn prompted the fourth phase of Chinese currency policy: a crawling peg against the U.S. dollar, starting in July 2005. Each day, the PBOC fixed a reference rate for the renminbi against the dollar, and permitted the currency’s value to fluctuate within a narrow band around the reference. The daily trading band was initially set at 0.3 percent (in either direction), and subsequently widened to 0.5 percent in 2007 and 1 percent in April 2012. Over eight years, the crawling-peg system delivered a 35 percent appreciation against the U.S. dollar and a 40 percent appreciation of the REER.

In light of the vociferous criticism China endured for its undervalued exchange rate, it is striking in retrospect how swift Beijing was to change its currency regime once a serious external imbalance appeared. As late as 2004, China’s merchandise trade balance was around 2.5 percent of GDP, just slightly above the 15-year average. In 2005 it jumped to 5.5 percent, and the decision to let the currency rise was immediate. At first the rise was too timid, and the trade and current account balances continued to expand. But by mid-2007 the appreciation pace picked up to 5 percent a year. The ultimate result of the crawling-peg regime was a reduction in the current account surplus from its peak of 10 percent of GDP in 2007 to the measly 0.8 percent recorded in the first quarter of 2014.

As the above account makes clear, mercantilist motives historically played a secondary role in China’s exchange rate policies—and after 2007 China pursued an anti-mercantilist policy of deliberately shrinking its trade surplus. Beijing’s bigger concerns were the exchange rate’s role in facilitating a broad shift from administered to market prices (1978-1995), as an anchor for monetary policy (1995-2013) and as instrument for correcting an external imbalance and promoting a shift in favor of domestic demand (2007-2013). Lying in the background was the idea that a relatively stable exchange rate was strategically beneficial. After the Asian crisis, foreign investors were reassured that China was a safe place for direct investment; and after the 2008 global crisis the case for the renminbi as an international trade-settlement and portfolio investment currency was strengthened.

Given this history, we can safely rule out the theory that this year’s devaluation is a tactic to boost exports at a time of flagging domestic demand. An explanation that better fits both the recent facts and the historical context is that, in line with the Third Plenum Decision, Beijing wanted to make the exchange rate more flexible and market-determined. But it faced a problem: for almost 18 months from September 2012, the daily market rate of the renminbi was at or near the top of the 1 percent trading band, because investors assumed (rightly) that the Chinese currency would always go up: it was a “one-way bet.” The one-way bet caused large-scale capital inflows that were routinely much larger than the monthly trade surplus. Under these conditions, if the central bank had simply widened the daily trading band, traders would quickly have pushed the value of the currency to the top of the new band, and even more capital would have flowed in. To prevent this outcome, the PBOC in late February starting pushing down its daily fixing, and ordered Chinese state-owned banks to sell renminbi and buy dollars. In mid-March, when the “one-way bet” psychology had been chased out of the market, PBOC doubled the daily trading band to 2 percent.

Welcome to the Managed Float

It is clear that China has entered a new phase of currency management, and the rulebook that has worked well since 2005 must be heavily revised. Two observations inform this judgment. First, the main aims of the strong renminbi policy have been achieved. The current account surplus has been virtually eliminated, and at least one serious technical study of the currency (by Martin Kessler and Arvind Subramaniam of the Peterson Institute for International Economics), the structural undervaluation of the renminbi has been eliminated.

Second, the adoption of a 2 percent daily trading band means that, on a day-to-day basis, the renminbi rate can now be determined mainly by the market most of the time (since only at times of extreme stress do currencies move more than 2 percent in a day). This newfound capacity seems consistent with the broad aim articulated in the Communist Party’s reform agenda last November, of having market forces play a “decisive role” in resource allocation. A willingness to let the currency float more freely is also consistent with the apparent agenda to liberalize deposit interest rates within in the next two years, which implies shifting from a monetary policy that mainly targets the exchange rate to one that mainly targets a domestic money-market interest rate.

It is also clear, however, that the renminbi will not simply be left to its own devices: the float will be a heavily managed one. Mechanically, it will likely operate much like the Singapore dollar “basket, band and crawl,” or BBC system, with an undisclosed trade-weighted index target, a 2 percent daily trading band puts a limit on extreme movements and a periodic readjustment of the slope of the policy band to prevent a major misalignment of the currency emerging (as it did at the end of China’s hard-peg era).

Strategically, the two most important aims of Beijing’s exchange rate regime will be maintaining stability of both the current and capital accounts, and providing support for the emergence of the renminbi as a serious international currency. (For an analysis of the renminbi-internationalization drive, see China’s Global Currency: Lever For Financial Reform.)

The first factor basically means that when capital flows (in or out) threaten to become destabilizing, the PBOC will use the exchange rate to reverse those flows; the same applies to extreme movements in the current account. In effect, Beijing will try to keep both parts of the balance of payments in roughly neutral position, while it undertakes deep reforms of the domestic economy.

The second aim means that sustained depreciation is unlikely to be tolerated, since as the new kid on the block the renminbi still must convince global investors that it is a reliable store of value over the medium to long term. Yet intolerance for sustained depreciation is perfectly compatible with significant short-term depreciations lasting several months or more, to correct current or capital account imbalances. The days of the one-way bet are over.

The bottom line is that Beijing has made a decisive commitment to a much more flexible and far more market-driven exchange rate—exactly what the U.S. Treasury Department and the International Monetary Fund have been suggesting for years. This commitment means that the exchange rate will cease to be a major point of friction between China and its trading partners. The interesting question now is how quickly China will follow up with the even bigger task of liberalizing its domestic financial system.