What are the Intentions of the Three-day Devaluations of the Renminbi, to Boost the Economy or Something Else?
Visiting Fellow, RIETI
Many observers were stunned by the devaluation of the renminbi that occurred three days in a row. The People's Bank of China (PBOC) suddenly devalued the reference exchange rate of the yuan against the U.S. dollar by almost 2% on August 11, 2015, followed by further devaluations on the following two days, amounting to a devaluation of about 4.6% over the course of three days. Because the devaluation measures were not only unexpected but also larger than the market could have expected, the Nikkei Stock Average fell by more than 400 points over the two days of August 11 and 12. These measures could imply that the Chinese economic slowdown is more serious than expected, and that the authorities may have used them as a means to boost the economy by recouping the competitiveness of the country's exports.
Implications of devaluing the renminbi
Let me lay out the implications that the renminbi devaluation attempts hold for understanding future trends in the Chinese economy.
The Japanese media tends to overestimate the impact of exchange rates on the economy. However, it is no exaggeration to say that it takes at least three months or most likely as long as six months after a contract is signed in a trade deal for what was contracted to be actually delivered. This means that the current exchange rates will not impact actual trade until three to six months later (the so-called "J-curve effect"). Therefore, as PBOC Deputy Governor Yi Gang stated, the view that China is trying to stimulate its exports by devaluing the currency by 10% is groundless. Most likely, weakening the currency value as an active measure to jumpstart the economy should not be the true intention of the Chinese authorities. Even if so, the Chinese authorities' attempt to weaken the currency value would be washed out since other emerging economies are also expected to follow suit and intervene in foreign exchange markets to weaken their own currencies. In fact, the Korean won and the Indonesian rupiah have already weakened significantly as soon as the renminbi was devalued, and that must have made the effect of the devaluation already diminished.
The value of a currency tends to grow cheaper if the economy of the issuing country becomes stagnant. Given the time lag mentioned earlier, one could argue that if an economy is expected to become sluggish in the future, its currency tends to start becoming weaker now. In the case of the renminbi, however, because the PBOC has been actively intervening on a daily basis, the yuan's "reference exchange rate" (set by the government) does not necessarily reflect the actual situation of the Chinese economy in real time. In fact, since the Chinese economy began showing signs of weakness, many observers have argued that the reference exchange rate has been overvalued more than the market perceptions, and thus it does not fully reflect the weakness that the Chinese economy is experiencing, or will experience in the future. Therefore, it makes more sense to regard the current devaluation as a measure to correct the reference rate to better reflect the reality facing its economy.
Nonetheless, no one must have expected the Chinese authorities would devalue the currency three days in a row. As many market observers stated, this policy attempt suggests that the authorities have admitted (rather proactively) that the situation of the Chinese economy is not as good as they had expected. Considering that even the devaluation on the first day was enough to convince the market the authorities' admission to the sluggishness of the economy, devaluing for another two days is an indication that the government is considerably flustered. Stock prices in other countries appeared to be sensitive to such fluster of the second largest economy in the world.
Now, a natural question arises: Is the devaluation attempt compatible with the direction of financial liberalization as well as the efforts of "internationalizing" the renminbi, both of which the Chinese authorities seem to have actively pursued lately? China has been strongly advocating that its currency be included in the basket for the special drawing rights (SDR) of the International Monetary Fund (IMF)—virtual currency used for rescue funds when a member country lacks foreign reserves due to a financial crisis—along with other major currencies such as the U.S. dollar, the euro, the yen, and the British sterling. In order for this to happen, many experts have argued that the Chinese government needs to liberalize its financial markets and minimize its meddling with the markets, which was believed to have been a consensus of both the PBOC and the Communist Party.
Some argue that market intervention as has happened in the recent devaluation efforts would go against the trend of liberalization, while others claim that it would not necessarily go against the trend because the main intention of the government was to bring the reference exchange rate at par with the exchange rate more acceptable in the market.
It is probably difficult to adopt the latter view, however. While Chinese government authorities claim that the devaluation is only the result of changing the calculation method for the reference exchange rate, they do not and will not disclose any information regarding how the reference exchange rate is calculated in the first place and to what degree the government intervenes in the foreign exchange market.
What will happen? Boost the economy or encourage capital to further flow out of China?
It has been argued that a large amount of funds have already flown out of China even before the devaluation policy was conducted. Because the weaker renminbi means that one yuan is exchanged for fewer dollars, investors should expect that they should exchange the renminbi for the dollar before the renminbi becomes even weaker. The recent three-day devaluation would only make them more convinced that the renminbi would continue to weaken.
Ironically, the outflow of funds is actually a product of recent financial liberalization efforts that have been in place since the late 2000s. As one of the liberalization policies, regulatory controls on outward remittances and investments have been either lifted or relaxed. Now with the stronger expectation of weaker currency, the government may implement capital controls again so as to prevent or slow down the outflow of capital once it worsens in the future. However, there are plenty of ways to circumvent capital controls. Even before overseas remittances and investments were liberalized, many people seem to have conducted so-called misinvoicing—issuing an invoice with an amount different from the actual value of traded goods—to bypass regulatory controls. Thus, even if the Chinese government attempts to stop the outflow of funds, it will be quite difficult to do so.
Against this background, the question then is which of the two opposing forces would win, the expansionary effect of the weaker renminbi or the outflow of funds that may hurt the financial system? There is a chance that the devaluation could help the economy to recover with exports recovering more robustly than expected, thereby helping boost the economy. Or, there may be massive outflows of funds, which could cause severe cash flow problems among financial institutions in China. We just need to wait a little longer before we can see which scenario will prevail.
One worrying factor is that the Chinese economy is already showing some signs of deflation. The consumer price index is lower than the target set by the government (1.6% on a year-on-year basis in July against the government target of 3%), and the industrial wholesale price index was 5.4% in July, lower than the level from one year ago. If a recession is accompanied by deflation, as what happened in Japan during the 1990s, the Chinese economy will face a big challenge. We just need to keep a careful eye on the economy on that front.
August 18, 2015
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