China's currency moves this week rattled markets and raised worries of both a currency war and the exporting of deflation to the rest of the world. Many argued that the moves by the PBOC were done in desperation to prop up flagging growth. But, the implications going forward are much more benign. The devalue came on the heels of bad export numbers, and was probably done to relieve some pressure for exporters hurting from Beijing's linking of the CNY to the strong dollar. The engineered part of the devaluation is probably over, but there continues to be downward pressure on the CNY.
Downward pressures on the yuan are mainly market and economy driven. A strong CNY is politically driven. These two opposing forces are in flux.
By many measures the yuan is subject to downward pressure in the market due to slowing economic growth, central bank easing as the Fed is preparing to hike, and the currency is arguably the most overvalued major currency in the world (see chart below).
Real Effective Exchange Rates Percent Change Over 5 Years
A strong CNY is an important policy tool for China to: Force structural rebalancing within the economy, maintain control over inflation, reverse financial repression, maintain prudent monetary policy, and boost China's international reserve currency plans. China wants the IMF to include the CNY in its Special Drawing Rights (SDR) when it undertakes a once every five-year vote in a few months. The inclusion will help elevate the CNY to reserve currency status eventually. The push to make the CNY a major reserve currency is primarily a political decision by Beijing that has come at the expense of weaker economic prospects in the short-term.
The PBOC maintains significant control over the CNY for policy purposes. The currency is still only allowed to rise or sink 2% from the midpoint fixing. The significant control over the banking system allows Beijing to force banks to make trades in the direction mandated by the PBOC. Beijing has roughly $3.7 trillion in reserves to prop up the currency, and control over the printing of money in order to push down the currency. China can direct the CNY as it sees fit. Although the changes to the midpoint fixing mechanism will make controlling the currency more volatile going forward.
What happened this week:
August 10th saw the release of some of the worst trade data out of China in years. The declining exports were hurt by the CNY appreciation against most major trading partners as it remained stable against the strong USD for political reasons. The CNY rallied 17% vs. the EUR, 18% vs. the JPY, and 11% vs. the KRW for the year leading up to the devalue.
August 11th, the PBOC moved the CNY 1.9% lower vs. the USD. The devalue was accompanied by a methodology change for setting the daily fixing midpoint, allowing market forces to play more of a roll. That allowed China to shrewdly devalue and keep its CNY in the running for the IMF SDRs. The methodology change was welcomed by the IMF. By giving up some control in setting the midpoint, the PBOC will need to intervene more frequently in order to maintain its policy plans for the CNY. This will result in more volatility than seen in the past.
August 12th, the CNY midpoint was lowered again, and the currency fell to the lower end of the allowable range. The PBOC had to intervene in order to push the CNY higher, and the CNY closed 1% lower. On the week the CNY is down roughly 2.9% vs. the USD.
The market greeted the events with worry that Beijing was on the cusp of a major devaluation of the CNY in order to bail out economic growth. This in turn led to worries of igniting a currency war and the exporting of deflation. The PBOC made a statement that it was targeting a "stable and strong yuan." The CNY was unchanged for the rest of the week.
Where does the CNY go from here? China has no need to abandon its domestic and international policy agenda by dramatically driving down the yuan. The economy is weak but stable. Xi and Li and Zhou are not afraid of various messy market interventions along the way, but seem to be committed to instituting their policy agendas in the end. If Hu and Wen were still in charge, the CNY would be 20% lower and the PBOC would be printing money like mad to kick the economy back into high gear.
But, a slow drift down is not out of the question. The engineered part of the devalue may be over, but pressures on a lower CNY continue to mount. Given the market fundamentals and the changes to the CNY midpoint mechanisms blessed by the IMF, the possibility of a lower CNY has increased. A slow depreciation vs. the USD would not derail domestic reforms. China's currency has already rallied significantly against its other trading partners, and a modest rollback of that rally (as opposed to a major abrupt devaluation) would not be a setback to restructuring.