In a surprise move, China weakened its currency yesterday by setting the daily fix for the RMB 1.9 per cent lower, in its most significant devaluation since 1994. This has fuelled a great deal of speculation as to the reasons for this move and the ultimate implications for the Chinese economy and the rest of the world.
Of course, it is probably too early for a final verdict and a lot will depend on what happens next – whether this is a one-off move or the beginning of a more significant devaluation trend. But for now, it seems to me that this policy step is not a panicky attempt to shore up the Chinese economy in the short term, but rather a move consistent with the country’s longer-term reform agenda.
Some commentators see the move as an attempt by the Chinese authorities to stimulate the economy by making the country’s exports more competitive, with the collapse of China’s exports in July by 8.3 per cent year-on-year as the catalyst. The RMB has indeed strengthened significantly on a trade-weighted basis, by almost 17 per cent since mid-2014, mirroring the US dollar’s rally. This has weighed on Chinese exports and has also undeniably contributed to the tightening in broad financial conditions, partly offsetting recent policy easing on the monetary and fiscal side.
But the strength of the currency is not the only explanation for poor export performance. The main reason lies in the general weakness of external demand after the global financial crisis – a headwind faced by all emerging market exporters. So a small RMB move is unlikely to make a difference in this respect. Furthermore, the government still has plenty of ammunition to stimulate the economy – via monetary and fiscal measures that would help boost domestic consumption, supporting China's longer-term rebalancing objective. Indeed, we are likely to see more on both fronts over the next few months.
Instead of major economic stimulus, I think this devaluation is primarily about the desire to reform. The move is consistent with the People’s Bank of China’s efforts to further liberalise the foreign exchange market. This is particularly relevant in the run-up to this year’s IMF review on special drawing rights (SDR) basket inclusion, which currently consists of four main currencies: the US dollar, the UK pound, the euro, and the Japanese yen. Last week, the IMF highlighted operational difficulties in including the RMB into the SDR basket and encouraged the Chinese authorities to press on with financial reform. That might well have served as a catalyst for yesterday’s move. Further RMB flexibility brings the country a step closer towards formal reserve currency status.
What does the devaluation mean for the rest of the world? It remains to be seen. If there are further moves, exporters that compete with China would lose out – these are mainly emerging markets in Asia, but Japan and some European countries would also be vulnerable. Additionally, the first round impact would likely result in intensifying deflationary pressures for the rest of the world. And the associated US dollar strength could – once again – make the Federal Reserve delay the timing of its first rate hike.
For now, it is crucial to watch any further RMB developments over the next few days and weeks. These should clarify the picture.