Ming ZHANG

From June 2005 to July 2015, the Renminbi (RMB) appreciated 26 percent against the United States Dollar (USD). Meanwhile, the RMB's real effective exchange rate appreciated 57 percent. Since the second quarter of 2014, the appreciation expectation of the RMB against the USD in the market has been reversed to the depreciation expectation, which can be demonstrated by the change from negative to positive of the CNY-CNH spot exchange rate spread since then. The key reason for the reversal in the exchange rate expectation is that the RMB’s effective exchange rate appreciated too fast from 2013 to 2014, and this was unsupported by economic fundamentals. During that period, the RMB was still largely pegged to the USD, and the effective exchange rate of the USD appreciated very fast due to the exit of QE and the expectation of interest hikes.

From the second quarter of 2014 till July 2015, although there was a depreciation pressure, the exchange rate of the RMB against the USD remained unchanged. The intervention tool of the People's Bank of China (PBC) was the management of the daily opening price of the RMB against the USD. Before August 2015, the daily opening price of the RMB against the USD did not equal to the closing price of the previous trading day. Therefore, the PBC could offset the depreciation pressure by persistently pushing up the daily opening price of the RMB against the USD. The evidence of this intervention by the PBC was that, from the second quarter of 2014 to July 2015, the daily opening price of the RMB against the USD was consistently lower than the closing price of last trading day.

To show that it was determined to decrease its intervention in the exchange rate in order to facilitate the IMF’s inclusion of the RMB into its Special Drawing Rights (SDR) basket, the PBC initiated a reform of the RMB's daily opening price on August 11, 2015, and the key point of this move was to let the daily opening price of the RMB against the USD be more determined by the closing price of the previous trading day. This reform meant that the PBC was giving up its intervention in the opening price of the RMB. However, because there was a significant depreciation pressure on the exchange rate of the RMB against the USD, the result of the August 11 reform was the sharp depreciation of the RMB against the USD in mid-August 2015. On one hand, the depreciation pressure was so strong it seemed beyond the expectation of the PBC. On the other hand, the PBC was criticized because the RMB's depreciation was thought to be the critical factor behind the subsequent turmoil in both domestic and international financial markets. As a result, several days after the August 11 reform, the PBC was forced to intervene on the foreign exchange market again.

Because the PBC had already given up the management of the daily price of the RMB against the USD, the new tool used to stabilize the RMB's exchange rate was the open market operation, which meant that the PBC had to sell USD and buy RMB. Moreover, as a result of the RMB’s internationalization, there are two RMB exchange markets: the CNY market (onshore) and the CNH market (offshore). If the PBC only conducted open market operations on the CNY market, the exchange rate spread between the CNY and the CNH markets would expand, which would bring about stronger pressure for the RMB’s depreciation. Therefore, although without official acknowledgement, the PBC was believed to have conducted open market operations on both the CNY and CNH markets to avoid the depreciation of the RMB against the USD.

If the PBC did not allow the depreciation pressure of the RMB against the USD to be released, there will be certain costs. Instead of asking whether the PBC should let the RMB depreciate against the USD, we ought to examine whether we can afford the costs of maintaining the RMB’s stability.

The first cost of refusing the RMB's depreciation is the persistent outflow of capital. If there is a continuous depreciation expectation of the RMB against the USD, both residents and non-residents would prefer to exchange their RMB denominated assets into USD denominated ones, resulting in capital outflows. In the second quarter of 2014, China began to incur a financial account deficit. From the second quarter of 2014 to the second quarter of 2015, the accumulated financial account deficit was USD 200 billion. However, the amount of financial account deficit increased by USD 160 billion and USD 200 billion in the third and the fourth quarters of 2015, respectively. The reason of the worsening capital outflow was that, after the August 11 exchange rate reform, the depreciation of the RMB against the USD became aggravated rather than mitigated. If there were no significant depreciation, the PBC's effort to stabilize the RMB's exchange rate against the USD could not eliminate the depreciation expectation.

The second cost of refusing the RMB's depreciation is the shrinking of China’s foreign exchange reserve. By the end of January 2016, China's foreign exchange reserve was USD 3,230 billion, which implied that the scale of this reserve had decreased nearly USD 800 billion from its peak level. Although the valuation effect of the fluctuations of major currencies might have contributed to the shrinking of the foreign exchange reserve, the author's own calculation suggests that such valuation effect could only explain about one third of the foreign exchange reserve's shrinking, and that the rest would have to be attributed to the PBC's open market operations. In fact, the real losses suffered by the foreign exchange reserve might be much larger than the above mentioned number, if market rumors that PBC had tried to hide the real amount of USD assets they sold on the market are to be believed. If the depreciation pressure persists and the PBC continues to conduct open market operations, it is possible that China's foreign exchange reserve could decline further to below USD 2,500 billion by the end of 2016. To make things worse, the fast shrinking of foreign exchange reserve might intensify the RMB's depreciation expectation against the USD.

The third cost of refusing the RMB's depreciation is the weakening of the PBC’s monetary policy autonomy. According to the classical impossible trilemma, if the PBC is not able to control capital outflow but continues to maintain a stable exchange rate of the RMB against the USD, the PBC will not be able to implement an independent monetary policy. Under current circumstances, the decline of economic growth and the exacerbation of deflationary pressures require the PBC to loosen monetary policy by lowering the required reserve ratio (RRR) or cutting benchmark interest rates. However, due to concerns that monetary loosening will push down the interest rate spread between China and the US and subsequently exacerbate the depreciation pressure of the RMB against the USD, the PBC has postponed RRR and interest rate cuts for quite a long time, which has not only increased the downward pressure of the real economy, but also resulted in the fluctuation of the stock market. However, for a large economy like China’s, maintaining an independent monetary policy should be considered more important than maintaining a stable exchange rate.

The final cost of refusing the RMB's depreciation is the negative impact of an overvalued RMB to China's export growth. Although China's goods trade surplus was USD 578 billion in 2015, the reason for the huge trade surplus was not the good performance of the export sector, but rather the very bad performance of import growth. Out of the 12 months of 2015, China's export growth year over year was positive only in February and June. The weak external demand was one reason behind the dismal export growth, and the strong appreciation of the RMB's effective exchange rate was another important reason. If the RMB continues to remain stable against the USD, and the USD continues to appreciate against other major currencies in 2016, China's export sector will continue to face downward adjustment pressure. If the pressure is too significant, both economic growth and the labor market will suffer serious setbacks.

To summarize, if the PBC continues to maintain a stable exchange rate of the RMB against the USD and refuses to release the depreciation pressure, the Chinese economy will continue to face huge capital outflows, the shrinking of its foreign exchange reserves, the loss of its monetary policy autonomy, and negative export growth. These costs will continue to rise until they finally become unaffordable for Chinese economy. Therefore, the sooner the depreciation pressure of the RMB against the USD is released, the better it will be for the PBC and for the Chinese economy.

Last but not least, to avoid the downward overshooting of the RMB's exchange rate against the USD, the PBC should strengthen control on short-term capital flows, in order to avoid the vicious spiral between RMB depreciation and capital outflows. In addition, the Chinese government should consolidate the macro-prudential regulation regime to minimize the potential impact of the RMB's depreciation, such as the bursting of USD denominated debts borrowed by Chinese enterprises in the past several years.

Ming Zhang is a senior fellow from Institute of World Economics and Politics, Chinese Academy of Social Science.