Wednesday, August 12, 2015

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.


  1. Sir, could this be China's way of reacting to the impending TPPA? to fend off threat from other regional exporters...the like of Vietnam, Korea, Japan etc.

    1. @anon 4.00

      No, I don't think so. As of the latest round of negotiations, the TPP looks like it's dead in the water, so I doubt that it would be a factor in China's decision.

  2. I think you got this wrong mate as was the case with corruption, inequality (diminishing inter-ethnic gap), the purported oil-ringgit link and of course other stuff as debt-fueled consumption...remember...hehehehe

    I love being the contrarian but the data has been strongly supportive of that stance thus far so what the hell if I ruffle your feathers on this one too...who knows...though dont take it too personally, dude cos its par for the course when it comes to our exchanges... So here to being the angel's advocate once more.

    I see this move by the errr....err....Cs.... as a strategic gambit. A desperate attempt to stave of a US interest rate hike and thus restrain US capital from running away from this region.

    The C economy...has tried everything bar throwing the kitchen sink at its economy but its stalled in a rut precisely because global trade is still in a funk (see the well known proxy indicator called the Baltic index). The only way for the Cs to keep the party going is by relying on US capital trying to find better yields elsewhere than the US itself and that means the EM cohort etc and thus by default indirectly keep the splurge going and C's exports ticking..

    The C central bank threw close to 4 Trillion yuan at the economy back in 2009-2011 thereabouts but the limited effectiveness of such measures must be grating their nerves:

    "just about everyone in Beijing had come to the inescapable conclusion that former Premier Wen Jiabao’s crash stimulus program, authorized in late 2008, was a huge mistake, largely because it had resulted in grossly inefficient usage of capital, large asset bubbles, and far too much debt.

    They are doing it again this time around but with much less confidence amidst diminishing returns.

    You see for all its supposedly vaunted capabilities QE, stimulus or whatever its moniker has its limits...the Europeans will find out soon as did the Yanks and the Japs before them. is the start of that spiral into the inferno........

    So the Cs have to look outside to get the economy going and a Yuan devaluation is inline with that scheme of things:

    a. C exports become cheaper
    b. US compelled to postpone interest rate lift off thus giving relief to struggling EM's to binge on US capital searching for yields away from home
    c. EMs continue buying C's cheap stuff.... ..

    In short to keep the merry go round going, until the bolts come off....hahahahaha

    Warrior 231

    1. @Warrior

      Glad you're amused Warrior. Since the Chinese aren't telling, your explanation is as good as any.

    2. Dude, I was just wondering given the free time I have on my hands....I was just wondering why would the Cs devalue their currency given that they want to "internationalise" it via market ops.

      I mean they are aiming for reserve currency status as you say, right? but who would want to hold such a currency if the very country that's issuing it bastardises it. Doesn't make sense, right?

      I reckon the C economy is in a ditch and not responding to all fiscal efforts at resuscitation and their banks could be in trouble. This smells like a strategic gambit to export their way outta trouble .

      Warrior 231

    3. @Warrior 231,

      Do you rate India as a factor?

      I've been listening to BBC world service and they keep on drumming India as the biggest Democracy and next "China" in term of economic boom.

    4. @Warrior

      Market pressure dictated China's devaluation. In case you haven't heard, they spent more in reserves in August defending the "devalued" Renminbi, than BNM has in total. In other words, they partially bowed to the market's judgement that the Renminbi was overvalued and needed to come down. In fact, the devaluation looks incomplete - they need to go down another 5%-10%.

      The devaluation won't really be a boost to exports, as global demand remains weak. The main impact is likely to be to keep exporters afloat by increasing their margins in local currency terms. Value-added in China's manufacturing remains low - exchange rate movements won't have much of an impact on export competitiveness.

  3. So dude, while your thesis more or less echoes this:

    Mine is given support by this:

    In the United States, a cheaper yuan could weaken American exports to China, widening the already large trade deficit with China. And it will add fuel to the arguments of American politicians and businesses who claim the yuan is undervalued. It also might add pressure on the Federal Reserve to delay raising interest rates, as a rate hike would put upward pressure on the dollar and make U.S. exports even less competitive.

    See 4 birds with one stone......cheaper C US interest rate lift flight of US capital from region and EMs....continued binging on cheap C exports all gift wrapped in Yuan "internationalisation" red cloth.....hahahahaha

    And the above are the real reasons for the move not some noble "internationalisation" motiveor any trilemmas....

    You see when dealing with the sly Cs, always remember that the rule of the game "what is said is not what is meant for the unsaid is the real intent" ( my own haiku). Sun Tzu "algorithms" at work mah...hahaha

    Warrior 231

  4. Hisham, why are ASEAN currencies and the commodity prices weakening FURTHER following the yuan devaluation? I don't get the picture


    1. @Fung

      Bear with, this is a little convoluted:

      The devaluation is an implicit admission by the Chinese authorities that their policy easing has so far not worked and needed to be strengthened. By implication, this could mean that China's growth is much weaker than people expected. It doesn't help that nobody trusts the official statistics that China produces.

      If this suspicion that China's growth is much weaker than previously assumed, or that there are problems in the system that the authorities know about but aren't letting on, that would require a rerating of all the commodity markets and the countries that produce them.

      So the gut reaction is: sell all commodity producers and exporters exposed to China.

    2. Thanks Hisham. It shows that I'm painfully stupid, the world is already reacting to it and I'm here asking this question.

      Fundamentally speaking, are the ASEAN currencies undervalued right now? Ringgit is obviously oversold, but what about the others?


    3. Fung, everyone's undervalued. The more correct question would be - how much is the USD overvalued?

    4. Hi Hisham & Fung,

      I am a but a budding 2nd year Econ student, and would like to know if the following rhetoric is a reasonable response to Fung's question.

      On ASEAN currencies: All things being equal,the Yuan devaluation would mean that 1) Chinese exports become more competitive relative to ASEAN exports (Assuming that we export similar products) 2) Chinese demand for ASEAN exports falls, as our goods become relatively more expensive to the Chinese - Resulting in net devaluation for ASEAN currencies so that the trade economy shifts back towards competitive equilibrium

      On commodity prices: The Chinese slowdown has already caused a bearish global commodity market, as Chinese demand has fallen for raw materials used for manufacturing and production. A weakened Yuan exacerbates the situation, as raw materials rise in relative price to the Chinese, which causes commodity demand of the world's second largest economy to dampen further. This results in a further aggravated decline in global commodity prices.

      I recognize this is a very basic view of the situation, perhaps Hisham can add some additional meat? :D

    5. @anon 9.54

      Sorry, I missed your comment for some reason, so apologies for the late reply.

      There's two components to ASEAN exports to China. One is intermediate goods for re-export, and two is raw materials for domestic consumption. The impact of exchange rate movements on trade of the former is rather minor, due to China's relatively low level of domestic value-added. The latter has been gaining in importance over the past decade, especially after the GFC. So you explanation 2) is probably a lot more valid than explanation 1).

      On commodity prices, spot on.

  5. Hi Hisyam, but PBOC could just sterilise its forex intervention, right? And given it has a gigantic forex reserves, I don't think it's gonna be a problem even if it wants to maintain the peg even longer.

    1. @Nazri

      Absolutely right. But think about what sterilisation means in this context.

      Actually, flip the whole idea on its head. Sterilisation of supporting a currency means buying government or central bank securities on the interbank market. China wants to ease monetary policy i.e. put more money into circulation. But the need to sterilise the loss of reserves is actually hampering that.

      In other words, the selldown in reserves is "sterilising" the monetary policy easing, if you get what I mean.

    2. I don't quite understand what you mean.

      Okay, say PBOC sell $10 billion of reserves to support yuan. Without sterilisation, an equal amount of yuan would be taken out of the system. So, PBOC needs to buy $10 billion worth of yuan denominated bonds to sterilise it.

      It's true that the government wants to do more policy easing. Since the selldown in reserves is "sterilising" the monetary easing, couldn't it just buy more yuan bonds in the market? Say buy like doubled the amount, $20 billion, in my example.

    3. @Nazri

      Yes, they could, and it would be ineffective.

      The more money you put into the system, the more the exchange rate will tend to weaken (supply>demand) and the more reserves they would have to expend to maintain the peg, leading to a greater sterilisation impact on domestic monetary conditions. Nasty.

  6. I see.

    So, sterisation of sell-down in reserves would be effective only in times when the central bank wants to maintain money supply or shrink it, ie tightening monetary policy.

    And it is ineffective, when it wants to increase the money supply, ie easy monetary policy.

    And the reverse for sterilisation for an increase in reserves.

    I hope my understanding is correct here.

    1. @Nazri

      Yes, that's about right. The difference is that it's easier when trying to sterilise an accumulation of reserves, because there's no limit to the amount of domestic currency and debt you can issue.

      It's harder the other way around because the amount of reserves and debt instruments outstanding are hard limits.

  7. Don't mind if I ask a question for personal reasons. So, after all this China-induced carnage, are things (currency exchange rates) going to stabilize and go some way back to what they were or are things going to get worse?

    I have an expensive cancer op in the UK in September and the Pound has surged against the Sing dollar since July (2.09 to 2.2). Should I buy all the Pounds I can now or should I wait?

    1. @The Slug

      I'm very, very sorry to hear that. I hope things go well with you.

      Bearing in mind that accurate exchange rate forecasting is virtually impossible, I would go ahead and convert now. The consensus trade over the past two years is to sell everything and buy USD, because of the pending tightening of US monetary policy. The BOE is expected to move only next year. My feeling is that the hot money will shift to the Pound once the Fed makes its move.

      I really don't know whether things will get better or worse, but the SGD is more likely to track the CNY than the USD or the GBP. If you want to spread your risk a bit, do partial conversions over a period of time. That way, whatever happens, you'll only have partial buyers remorse, instead of making an all or nothing bet.

  8. Hi Slug

    Sorry to hear of your illness and sincerely pray that you get better.

    By the way, hope this may offer a bit of guidance.

    I think the surge in GBP in relation to SGD is temporary as the BOE is beginning to get cold feet of any tightening even in Q1 next year as indicated above. So it wouldn't do you any harm waiting a while longer and see how things pan out. All the best.

    Warrior 231

  9. Thanks everybody... I don't know what the text book economic analysis to insurance is... But I sure wish I bought it... sniff

  10. Hello Hisham.

    Thanks for taking your time writing this piece. It has certainly taught me a lot about how economics are in the real world.

    If it's okay with you, there are two questions I wish to ask:

    1) I'm curious about what will happen following this move by PBOC. When the Yuan exchange rate are eventually determined by the market, would it affect the international trade sphere?

    2) I can sort of understand how the regional distribution of production chains could negotiate the effects of FX changes, but in the case of Malaysia, do we have enough regional distribution of production chains to guard against the impact of currency changes?


    1. @Amin,

      You're welcome

      1. It will definitely remove some of the price distortions involved. More importantly, use of the Yuan as a reserve currency would reduce transaction costs.

      2. 70% of Malaysia's trade is in intermediate goods. Our entire electronics industry is part of the global supply chain