The People’s Bank of China stunned financial markets late Monday with a surprise 2% depreciation in the renminbi. Rather than a change in policy, the Chinese central bank described the move as a “one-off depreciation”. The decision saw the renminbi’s daily peg against the dollar drop from 6.2298 renminbi against the U.S. dollar to 6.1162 on Monday.
Global currency markets were roiled by the move, with analysts calling it another aggressive step by China in the ongoing “global currency wars”.
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Renminbi devaluation is response to strong dollar
A statement from the PBoC explaining the currency devaluation pointed to a continuing strong U.S. dollar and the rapid recent appreciation in the renminbi real effective exchange rate as important macro considerations in their decision. China analysts have been expecting the Chinese authorities to take steps to support its economy and faltering stock market, but most had been projecting interest rate cuts or other stimulus measures rather than a currency devaluation.
Monday's move is part of larger foreign exchange market reform effort
A number of analysts have also pointed out that foreign exchange market makers in China are now required to submit fixing quotes to regulators referring to the previous day's USD-CNY spot market closing price (in relation with supply and demand and major currency movements).
In its statement, the PBoC emphasized that the USD/CNY fixing has deviated significantly from the market spot rate for some time now, weakening the benchmarking function of the fix. Given China's domestic FX market is developing and market makers have strong risk management capabilities, the central bank is beginning to move towards a market-oriented fixing to more accurately reflect market demand and supply.
The central bank also laid out the next steps in the planned exchange rate mechanism reforms. The first step is to let the market play a larger role in determining the exchange rate, ending regular FX interventions and permitting more flexibility in exchange rates. Second, boosting foreign exchange market development by broadening the availability of forex products, adding more exchange rate trading hours, bringing in qualified foreign investors and promoting a single exchange rate in the onshore and offshore markets. The Chinese FX regulators also emphasized the need for risk controls and macro prudential measures given rapidly increasing cross-border flows.
Paul Mackel and team at HSBC Global Research Currencies also suggest there is another reason for PBoC's announcement of foreign exchange market reforms. In their report of August 11th, the analysts note: "We believe the PBoC is accelerating reforms to raise the chance of the RMB's inclusion in the IMF's SDR basket. Although it is not explicitly mentioned, it is nevertheless understood that a reserve currency cannot be a highly managed one, which could potentially deviate from its underlying fundamental value thereby resulting in eventual instability. That was indeed the risk for USD-CNY, which has been held very steady, despite ongoing capital outflows from China. We note that the PBoC also pledged further FX reforms - such as the extension of the CNY trading hours and promoting convergence between the onshore and offshore exchange rates – in their Q&A which are important in the technical considerations of potential RMB inclusion in the SDR."
HSBC says now opportunity to position for further China interest rate cuts
In their August 11th Flashnote China: Implications of the exchange rate reform on rates, HSBC Fixed Income Research China analysts André de Silva and Fin-Ru Tan note that China’s interest rate swaps and bond yields moved up immediately after the announcement of PBoC's reforms to its USD/CNY fixing mechanism. de Silva and Tan argue these yields spiked because of worries that monetary easing has become less likely following the depreciation of the yuan, but that these concerns are misplaced.
Moreover, the HSBC analysts say that this market misinterpretation of the central bank's move is an opportunity to get on the right side of the China interest rate trade. "We find this reaction counterintuitive as the exchange rate reform suggests that the central government is still focused on easing measures and looking for ways to prop up growth. The potential for more capital outflows following the depreciation also points to a greater need for reductions in the required reserve ratio (RRR). HSBC EM Rates Research therefore views the jump in rates as a good entry opportunity for investors to position for further monetary easing. We still recommend receiving 5yr NDIRS (entry: 2.74% on 15 July, current: 2.79%, target: 2.50%, stop: 2.90%)."