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Same-Day Analysis

China Abandons Currency Peg to U.S. Dollar Ahead of G20 Summit

Published: 21 June 2010
China's central bank, the People's Bank of China announced over the weekend that the Chinese renminbi will depeg from the U.S. dollar, as pressure mounted again for a revaluation in the lead-up to the G20 summit next weekend.

IHS Global Insight Perspective

 

Significance

This is the most important foreign-exchange policy adjustment that the Chinese government has undertaken since the initial depeg from the U.S. dollar in the summer of 2005, and marks the end of the temporary re-pegging to the U.S. dollar started since the onset of the global financial crisis in the middle of 2008.

Implications

Externally, the forex move will help China deflect criticisms on its currency policy at the G20 meeting, and reduce tensions between China and its major trading partners. In addition, pegging to a basket of currencies will lead to currency risk diversification that will benefit the country's exports sector. Domestically, greater flexibility of the renminbi exchange rate will lend the Chinese central bank much needed monetary independence to tackle domestic inflation.

Outlook

The initial revaluation of the renminbi will be quite modest, considering that the country's trade surplus has been shrinking, and that the effective exchange rate has already appreciated significantly over the past one and half months. The longer-term impact of the depeg on global imbalance is likely to remain minimal.

China's Second Forex Reform

The People's Bank of China (PBoC)'s announcement last weekend was made at a time when market expectation for a Chinese currency revaluation had been diminishing quickly amid the Eurozone debt crisis and shrinking trade balance, while political pressures for the revaluation have been ramped up again ahead of the G20 summit, which is to be held next weekend (26/27 June) and until last weekend had been widely expected to provide western economies a forum to denounce China's renminbi policy. There had been also building pressure in the United States to take aggressive action against China, led by Sander Levin of Ways and Means Committee. With the announcement of the new renminbi policy, China will deflect the risk that its foreign-exchange policy becomes a focus of criticism at the summit, as well as risks with further heightening of trade tensions with its major trading partners, the United States in particular.

The depeg marks the most significant currency move that the Chinese government has made since the global economic downturn started in 2008, and is regarded as the second forex reform since 2005. China abandoned a peg with the U.S. dollar in the summer of 2005 and adopted a peg with a basket of currencies—in which the U.S. dollar still holds a predominant share, but effectively returned to a peg to the U.S. dollar in August 2008 with the onset of the global financial crisis. The renminbi had appreciated by 21% against the U.S. dollar between de-pegging in 2005 and the suspension of appreciation in August 2008.

Nevertheless, the PBoC has ruled out the possibility that there will be a one-off major revaluation of the Chinese currency as in the 2005 forex reform, according to a news release coming out just a day after the initial announcement. However, the daily trading band will return to 0.5%, the published trading band that had been followed prior to the 2008 downturn, from the current 0.3%—adopted during the global financial crisis though never officially announced.

Such stress on a gradualist approach on currency has obviously again fanned Congressional flames. Senator Charles Schumer is quoted in the Financial Times as saying, "Just a day after there was much hoopla about the Chinese finally changing their policy, they are already backing off…It vindicates our initial scepticism. We intend to move forward as quickly as possible with legislation." Clearly, this is not the end of U.S.-China currency tension; but with China having tabled a currency appreciation, it will be harder to push through aggressive anti-China legislation.

Macroeconomic Context

The latest renminbi move comes amid heightened inflationary pressure in China and continued consolidation of the country's exports sector recovery. The consumer price index (CPI) rose to a 19-month high of 3.1% year-on-year (y/y) in May, crossing the 3% inflation threshold set by the monetary authority for the first time since China walked out of the deflationary zone. Asset price inflation was still serious, as the average housing selling price in China's 70 major cities continued to post a strong increase in May, at 12.4% y/y, the second highest growth recorded since China's real estate market bottomed out last year.

The country's exports sector also fared much better in May than expected. Exports growth accelerated to 48.5% y/y in May, a record monthly high since December 2003 and a marked acceleration from 30.5% y/y growth recorded in April. This brought China's cumulative exports growth in the five months through May to 33.2% y/y, up from 29.2% y/y in the first four months. Trade surplus also shot up to US$19.5 billion in May, the largest of this year. Nevertheless, overall surplus in the first five months was still down by nearly 54% from the corresponding months of last year.

Outlook and Implications

Slow Revaluation

Based on the statement of the PBoC, it's clear that there will be no one-time revaluation as in July 2005. Also, the pace of appreciation after the depeg will be very modest, which is consistent with IHS Global Insight's expectation. Even without the narrowing of trade surplus this year, it is unlikely for China to allow significant appreciation, especially in the initial months after the depeg. Indeed, the Ministry of Commerce will be fighting tooth and nail to protect exporters' margins amid rising wage costs and a weakened eurozone. While it is clear that an appreciation is in China's interest in the long run, policymakers will not want to rock the boat as the recovery is still consolidating.

China was ready to make this forex move sometime this year—with or without the recent flare-up of renminbi controversy in the U.S. Congress and the G20 meeting this week, after export demand recovery starts gaining traction. Nevertheless, the Europe debt crisis has brought some hesitancy and delayed the move, as export demand became more uncertain and the euro dropped sharply to induce a sharp appreciation of China's trade-weighted exchange rate in the last six weeks.

There are some truths in Beijing's counter to international criticism of the renminbi repeg. By holding the currency fixed after the 2008 financial meltdown, the renminbi took a huge hit against currencies of its non-U.S. major trading partners as those currencies tanked against the dollar. Effective exchange rate of the renminbi shot up nearly 12% in March 2009 from the average for August 2008—when the revaluation against the U.S. dollar stopped. Despite a subsequent pullback, the recent plunge of the euro has again driven up China's effective exchange rate, with the average for June as of 18 June still representing a gain in value exceeding 6% from the monthly average for August 2008. As such, the room for significant revaluation going forward is quite limited in the short term, which has provided the PBoC the justification for forgoing a one-off big revaluation as in 2005.

China Gains from Forex Move

Given the rapid weakening of the euro, depegging from the U.S. dollar and repegging to a basket of currencies that includes the euro, could be advantageous to China due to the benefits of risk diversification. It may help partly hedge the risk of further euro depreciation against the U.S. dollar, although at the same time increasing its exposure to possible future appreciation of the euro. As noted by the PBoC, the shift in China's renminbi stance will help China "weather the external shocks in different scenarios".

China will also gain from increasing the exchange-rate flexibility at a time when monetary independence is increasingly valued as inflationary trends in China and the United States start diverging. While inflationary pressure has been building up over the past six months in China, both in asset prices and general inflation, to the extent that it warrants more aggressive tightening, low inflation in the United States and the uncertainties in the Eurozone are expected to make the Federal Reserve of the United States stay on hold for an even longer period of time.

In addition, the problem of hot money inflow induced by the one-way bet provided by steady appreciation (which would have been counterproductive if part of the aim of the depeg was to fight inflation) is much less serious now, with the heightened uncertainty in the real estate market specifically and a possible hard landing of the economy in general.

Limited Impact on Global Imbalance

In terms of global imbalances, an appreciating yuan and more market-driven mechanism is a necessary but not sufficient condition for economic "rebalancing", both domestically and internationally. Even though China's currency appreciated 21% in the three years through mid-2008, there has been little impact on narrowing China's trade surplus. Trade surplus with the United States continued to balloon in the three years following the initial depegging, at an average rate of 20.8% during 2005-08. Indeed, there are many other important factors for rebalancing, including wage increases, resource price reform, necessary financial sector reforms (credit allocation is skewed towards urban areas and large state-owned enterprises that can provide collateral for loans but are the least efficient, while credit for private sector and rural small and medium enterprises is lacking), and monetary policy maturity (a more market-driven exchange rate will allow a more independent monetary policy. Additionally, the use of interest rates rather than bank lending quotas for monetary policy will re-orient the economy). However, these will all take time for implementation.
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