The Chinese Yuan

Foreign Exchange Rate Policy:

The Historical Background,

The Justification of the

Recent Devaluation

And the Potential Implications

Chenxuan Ye 16th August 2015

Contents

1. Abstract..................................................................................................................3

2.Keywords................................................................................................................3

3.Introduction.............................................................................................................4

4.Literature review.....................................................................................................5

5.Analysis

Historical background.................................................................................................6

Justifications for the policy ........................................................................................9

Policy implications.....................................................................................................12

6. Conclusions…………….........................................................................................14

7.Reference..................................................................................................................15

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Abstract

In order to investigate the possible implications of the largest-ever CNY exchange rate

devaluation adjustment (1.9%) by the People’s Bank of China in history on 11st

August 2015, this paper begins by providing a historical overview of the evolution of

China’s foreign exchange rate policies. The passed decades have witnessed the reform

of CNY exchange system towards free market fluctuations. The paper then discusses

several justifications for this huge and sudden strategic movement with both internal

and external economic factors. Lastly, it turns more insight into the potential effects of

the policy: limited exports improvement, the potential future currency devaluation of

other Asian economies, and the structural changes on Chinese industries. This paper

provides descriptive data and a literature reference to document these arguments.

Key words: exchange rate devaluation; managed float; market reform;

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Introduction

Before July 2005, China had historically adopted a fixed exchange rate regime, with

the CNY being effectively ‘pegged’ to the U.S. dollar at a sustainable rate of 8.27

yuan/dollar. After 2005，a new ‘managed float’ system was launched with reference

to a basket of different currencies, allowing the CNY to fluctuate within a fixed range

of 0.3% based on the price issued by the PBoC. This so-called ‘dirty float’ regime

ensured the relative stability of the price of CNY and helped China generate a huge

amount of trade surplus.

However, on 11st August 2015, the Chinese Yuan experienced the largest one-day

slide (1.9%) in its exchange rate since the establishment of its foreign exchange

market in 1994, which created tremendous shockwaves across the world. Under the

new rules, the CNY is allowed to expand its fluctuating range as much as 2%

(Financial Times 2015). The western media and commentators begin to doubt: Does

the looser peg, playing the competitive role of a loser monetary policy, indicate that

China is on the edge of the commencement of another ‘currency war’? Is this policy

of PBoC in conflict with the government’s goal of shifting its export-driven growth

towards a more domestic-demand based growth? Could this action be regarded as a

step towards the marketization of exchange rate?

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A Brief Review of Literature

The China’s foreign exchange policy had a prolonged history of controversy. The

People’s Bank of China has been accused of its interference on the foreign exchange

market and the CNY has generally been criticized as being undervalued. Goldstein

(2004) asserted that ‘China has been continuously “manipulating” its currency,

contrary to IMF rules of the game’, and he argued that a ‘two-step currency reform’,

which involved a shift from a ‘unitary peg’ to a ‘basket peg’, and a transition from a

‘peg’ to ‘managed float’ should be implemented. Eckaus（2004）also suggested that

China’s ‘excessively large foreign reserves’ provided a solid justification that CNY

was undervalued. On the other hand, however, according to Ferguson (2008), China’s

currency manipulation in the form of ‘devaluing it artificially, pegging it to the dollar,

and prohibiting its convertibility’ has been a major success in surviving the East Asian

financial crisis of 1997-8.

After the new currency regime was introduced on July 2005, the value of Yuan was

allowed to fluctuate between pre-set ranges of permitted rates, albeit the presence of

government intervention was still quite prominent. Woo (2010) argued that the

Chinese government should employ the CNY appreciation in order to ‘rebalance the

economy by increasing the consumption at the expense of trade surplus but not at the

expense of domestic capital accumulation’.

With a majority of western commentators in favor of the CNY appreciation, believing

that the Yuan was severely undervalued, the PBoC’s action of devaluation on 11st

August 2015, undoubtedly spurred tremendous debate about its mean purpose.

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Historical background

China’s currency regime could be categorized according to different political periods.

Between 1949 until the late 1970s, the China’s highly overvalued exchange rate was

fixed by the state as part of the country’s ‘substitution industrialization strategy’ as

part of the economic planning system (Peterson Institute for International Economics,

2009, para 1) for the purpose of reducing its heavy dependence on imports. The CNY

was almost inconvertible since the government placed strong exchange controls over

the money market. The overvaluation of the currency resulted in a lack of incentive in

domestic foreign trade companies, because the exchange rate faced by them was

significantly lower than the price they received on the international market, and for

each transaction, a loss would be incurred if the company attempted to convert their

earnings into Renminbi.

The second stage of the exchange rate system, characterized by a ‘dual-track system’,

was introduced in early 1980s, indicating a period of economic transition. The

‘internal settlement rate’ of RMB2.8 to the dollar, applied to all trade transactions,

was substantially diverted from official rate of RMB1.5 to the dollar. After the

abolishment of this rate, the government continued the CNY devaluation, and the

value reached a bottom at RMB8.70 to the dollar on 1st January 1994. Since then, the

CNY price was maintained at an approximate value of RMB8.20/dollar with slight

fluctuations until July 2005. Although there was strong government intervention

involved in the foreign exchange market, the value of CNY was generally regarded as

the equilibrium rate, which represents a fair value if it is left solely with the market

force. As shown by Figure 1.1, the CNY exchange rate was stabilized in accordance

with the value of dollar before 2005.

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Since July 2005, a new currency regime was launched in replacement of the former

RMB price vis-à-vis the US dollar. The CNY was revalued over 2.1% and a ‘managed

float’ system, allowing a fluctuating range of 0.3% around the middle rate, was

implemented with reference to ‘a basket of currencies’. This movement, illustrated by

Figure 1.2, suggested an increase in flexibility of RMB because the market demand

and supply were allowed to determine its value, though to a limited extent. As a

consequence, there was a gradual buildup in the current account surplus, in the form

of increase in holdings of foreign reserves, as indicated by figure 1.3. On April 14th

2012, the People’s Bank of China further expanded the RMB’s range of fluctuation to

1% percent, suggesting a general trend towards a more market-based exchange rate

regime.

Figure 1.1: The fluctuation of Nominal value of RMB relative to dollar, euro, pound and Yen between January 2000 and July 2007

Source: Wikipedia, the Nominal Value of RMB

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Figure 1.2: The trend of Chinese Yuan to 1 US dollar since the establishment of the new regime (July 2005)

Figure 1.3: The change in China’s foreign exchange reserves from 2001 to 2008

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The justifications for the devaluation

Despite the controversy over the main reasons behind this biggest-ever one-day CNY

exchange rate slide, several justifications could be extrapolated regarding the current

economic and political situation of China. First of all, according to Davies (2015), the

devaluation could be a ‘tactical shift’ made by the People’s Bank of China. By

allowing more market forces actively enter into the regime, China would endeavor to

achieve the ultimate goal of RMB internationalization through obtaining the Special

Drawing Rights (SDR), which serves as the ‘supplementary foreign exchange reserve

assets maintained by IMF’ (Wikipedia, 2015).

Besides, with a slow-down of the GDP growth and a general weakening in business

confidence of the economy, China has seen net capital outflows in 2015 in terms of a

sharp widening in the capital account deficit in the third quarter to an astounding

amount of $945 billion (China Daily 2015). The trend of China capital flows could be

illustrated in Figure 1.5. To prevent a drastic weakening of the currency, authorities

are forced to sell reserves, resulting in plummeting foreign exchange reserves by

about $340 billion (Davies 2015), as shown in Figure 1.6. As a consequence, the

domestic money market was tightened. Meanwhile, the inflation rate has fallen in

accordance with the shrinked economy. The continuous micro-adjustment of

monetary policy, namely, the reductions in reserve ratio requirements, was no longer

feasible in stimulating the economy. Thus, as an alternative effective means of easing

the monetary policy, devaluation might positively bring in a higher level of inflation

rate into the economy.

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To summarize this section, this devaluation would be a managed decline and an

‘orderly downward float’ (Davies 2015) by the PBoC as a step towards the SDR plan,

taking into account the effect of the market forces such as the unprecedented large

capital outflows caused by lower business confidence. Instead of imposing artificially

strong interventions to prevent further depreciation, a sudden and sharp lowering in

the value of RMB would reduce the long-term depreciation expectations. Meanwhile,

the PBoC’s capability to take authoritative control over foreign exchange market in

the light of its sufficient foreign exchange reserves might restore business confidence

in the very near future.

Figure 1.4: China business confidence between July 2012 and July 2015

Source: www.tradingeconomics.com National Bureau of Statistics of China

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Figure 1.5: China Captial Flows between July 2012 and July 2015

Source: www.tradingeconomics.com state administration of foreign exchange, China

Figure 1.6: China Foreign Exchange Reserves between July 2012 and July 2015

Source: www.tradingeconomics.com People’s Bank of China

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The Potential Implications arising from the devaluation

The unprecedented lowering in RMB’s daily reference rate indicates a new currency

regime with larger degree of freedom and uncertainties. In this section, the possible

effects arising from the devaluation would be discussed in order to weigh the relative

benefits and costs incurred in this action.

In theory, the devaluation would help China to reinvigorate its exports. Compared

with 2014, as illustrated by Figure 1.7, China has been facing relative sluggish exports

due to an upward pressure on RMB price dragged by the appreciation of dollar, the

weak global trade demand and the monetary-tightening intention by FED. However,

as argued by Financial Time (2015), the room for exports improvements would be

very limited. On the one hand, the major exporters of China no longer offer labor-

intensive products such as textile with high value of PED which is very vulnerable to

change in exchange rate; The capital-intensive industrial products have relatively low

PED and thus less likely to be affected by the devaluation. On the other hand, for risk-

management purpose, some large export enterprises would have been signed future

contracts which fixed the transaction price in a pre-determined level, regardless of

changes in the exchange rate.

The RMB devaluation might put downward pressure on other countries’ commodity

prices. According to Financial Times (2015), China’s ‘basket’ pegged and ‘managed

float’ currency regime has previously allowed its currency to rise with the dollar,

‘mopping up some of the deflation that would otherwise have been seen elsewhere’.

Under the new rules, other currencies tend to rise against the RMB, and the cheaper

Chinese exports might induce a decline in the general price level in other countries.

As a consequence, it is very likely that a majority of Asian countries might also follow

the pace of devaluation to prevent the potential outcome of deflation.

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The lowering in RMB’s value would cause huge structural changes for Chinese

enterprises. The winners would be those foreign manufacturing firms which locate

their branches in China. While most of their costs are in RMB, their profits would be

in other currencies that are rising against RMB. In contrast, for those Chinese firms

facing large burdens in dollar-dominated debt, the devaluation would increase their

borrowing cost. Financial Times (2015) listed the case of China Southern Airlines,

suggesting that ‘every 1 per cent fall in the value of the RMB costs it almost RMB770

million in additional debt servicing costs.’ Similar pressure would be added on those

Chinese property firms that issued huge amount of high-yield U.S. dollar bonds

offshore in order to finance their land purchase in China.

Figure 1.7: China exports from August 2014 to July 2015

Source: www.tradingeconomics.com General Administration of Customs

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The Closing Remark

China is not starting a ‘currency war’ or creating a ‘global economic mayhem’. The

policy goal has been no longer to promote a short-term boom in foreign exports or

attaining a high rate of GDP growth, but rather seeking to achieve the market-based

reform in the currency regime and boost the internationalization process of RMB.

Compared with the slow-motion decline, it might be in PBoC’s interest to see a

sudden large devaluation in RMB because the former has the potential to generate a

long-term depreciation expectation, creating a vicious cycle of capital outflows

leading to further devaluation.

As China is moving its steps towards the state of ‘New Normal’, the ‘quality’ rather

than the ‘high rate’ of growth would be largely prioritized. Under this context, China

would like to reach a ‘win-win solution’, instead of a ‘zero-sum game’ with the world,

promoting a further integration of its financial sector with the global financial system.

Hence, CNY currency regime also needs to undertake marketization reform to

increase its flexibility. Though it is hard to have a complete separation of the

interferential tools by the Chinese government with the currency regime immediately,

the PBoC’s role in the exchange rate market would become increasingly limited, as

the past decades have also witnessed the transition of its ‘grabbing hand’ towards

‘helping hand’.

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ReferenceChina Daily (2015) China sees volatile capital outflows in 2015. Retrieved 16 th

Feburary, 2015 fromhttp://www.chinadaily.com.cn/business/2015-02/16/content_19601710.htm

Davies. G (2015) Has China just pressed the escape button? The Financial Times p.10

Eckaus.R.S (2004) Should China Appreciate the Yuan (Jan) p.19 Massachusetts Institute of Technology, Department of Economics

Financial times (2015) Asia Inc weighs impact of renminbi devaluation. Retrieved 14th August 2015 from http://m.ftchinese.com/story/001063505

Ferguson.N (2008) The Upsides of Currency Manipulation: How China Survived the East Asian Crisis of 1997-8 (Jan) p.8 Harvard University, Department of History

Goldstein.M (2004) Adjusting China’s Exchange Rate Policies（May）p.2-3 Dennis

Weatherstone Senior Fellow, Institute for International Economics

Peterson Institute for International Economics (2009) Evolution of China’s Exchange Regime in the Reform Era, fromhttp://www.piie.com/publications/chapters_preview/4167/01iie4167.pdf

Wikipedia (2015) The Special Drawing Rights. Retrieved 14th August 2014 fromhttps://en.wikipedia.org/wiki/Special_drawing_rights

Woo.W.T (2010) Understanding the Sources of Friction in U.S.-China Trade Relations: The Exchange Rate Debate Diverts Attention Away from Optimum Adjustment (Jan) p.23-24 Brookings Institution, Washington DCUniversity of California, Davis; Central University of Finance and Economics, Beijing

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