Monetary Policy and the Yuan

In a shock move yesterday, the PBOC announced a sharp downward revision in the Yuan’s reference rate, with another one coming today. This de facto devaluation has had repercussions across the world, with some speculating that it would even put the Fed off from raising interest rates in September. It’s certainly the catalyst for the Ringgit moving past RM4.00 to the USD this morning.

There’s all kinds of speculation as to why (the devaluation I mean). Off hand, I would say the notion of currency war and regaining trade competitiveness is grossly mistaken. With regionally distributed production chains, the impact of FX changes on competitiveness have gradually been disappearing.

In my mind, there’s a few things to consider here:

1. For the past couple of years, China has been grappling with a slowdown in its economy. Policy intervention has included interest rate and reserve requirement cuts, targeted fiscal expansion, and a semi-resolution of the local government debt problem;
2. At the same time, China has stated ambitions to add the Yuan to the IMF’s SDR. A necessary precondition of this is a gradual opening up of China’s capital markets (i.e. the lifting of capital controls);
3. The Yuan has been allowed to fluctuate in a very narrow band against the USD since about the beginning of 2013, after a substantial appreciation since it’s floating in July 2005;
4. Since about the middle of 2014, China has been haemorrhaging international reserves.

Put all those together and the picture I get is this:

We have two monetary policy objectives – easing domestic monetary policy to support economic growth, and the long term aim of internationalising the Yuan that requires the opening of the capital account – that are incompatible with the Yuan peg against the USD. It’s the monetary policy trilemma again.

The loss of international reserves is key here. Unlike what I’ve said about the Ringgit, the Yuan peg means that China IS living in a Bretton Woods world. At the previous peg, China would have continuously lost reserves until it ran out (although given the hoard they’ve accumulated, that might take some time).

More importantly, the sell down in reserves is inherently deflationary. Utilising reserves implies buying Yuan to maintain the peg, which reduces liquidity in the interbank system and has consequences for credit creation and financial stability. This is directly at odds with the short term goal of supporting China’s slowing growth rate via monetary and fiscal expansion. Something had to give, and quite sensibly the PBOC decided the peg has to go.

So what we’re seeing here is not just a “devaluation”, but really a fundamental shift in China’s monetary policy regime. The PBOC have all but declared their intentions – we’re going to see a gradual widening of the FX band, and further liberalisation of capital controls and the interbank market. The peg will gradually fade into irrelevance, and the Yuan exchange rate will (eventually) become largely market determined. There will be the occasional backsliding, but that’s par for the course with developing economies. In the meantime, allowing the Yuan to depreciate would allow the PBOC’s monetary policy actions to gain full traction in the domestic economy.

The bottom line here is that this is really about China’s domestic monetary conditions, not external competitiveness.