As Growth Slows In China, Its Central Bank Devalues Currency By A Record 1.9%

China’s Central Bank, The People’s Bank of China (PBOC), has weakened the yuan’s daily reference rate by a record 1.9 percent on Tuesday and says it will strengthen market-oriented reforms in addition to increasing two-way market volatility, allowing depreciation to counter a slump in the nation’s exports.

Following the move by the PBOC, the yuan dropped an unprecedented 1.6 percent and fell to weakest level since Sept 2012.

The PBOC said in a statement that the reference rate depreciation was a one-time adjustment to reflect mid-point reforms, adding that it will strengthen the market’s role in the fixing and promote the convergence of the onshore and offshore rates.

The Central Bank said it will decide the yuan mid-point rate based on market makers’ quotes together with the closing quote starting on Tuesday. Improving the market maker quote system will make the mid-point more market-oriented, the PBOC said.

China’s Central Bank said it will also accelerate deregulation of its forex market, lengthen trading times, and introduce qualified overseas participants.

The PBOC also said that it will keep the yuan stable at a reasonable level and that the yuan’s effective exchange rate was stronger than that of other currencies, which is a deviation from market expectations, but will give room for China to adjust the rate.

So why did the PBOC devalue the yuan’s daily reference rate by a record 1.9 percent?  The PBOC’s spokesman said:

We noticed that the central parity of RMB against US dollar of 11 August changed(in the depreciation direction) by nearly 2% compared to that of 10 August. The following two factors may be relevent. First, after the improvement of the quotation of the RMB central parity, the market makers may quote by reference to the closing rate of the previous day and, therefore, the accumulated gap between the central parity and the market rate received a one-time correction. Second, a series of macro economic and financial data released recently made the market expectation diverge. Market makers paid more attention to the changes of market demand and supply. Compared with the closing rate of 6.2097 Yuan per dollar in the previous day, today’s central parity depreciated by about 200 bps. The market still needs some time to adapt. The PBC will monitor the market condition closely, stabilizing the market expectation and ensuring the improvement of the formation mechanism of the RMB central parity in an orderly manner.

Why choose now to devalue?  The PBOC’s spokesman said:

Currently, the international economic and financial conditions are very complex. The U.S. economy is recovering and markets are expecting at least one interest rate hike by the FOMC this year. As such, the U.S. dollar is strengthening, while the Euro and Japanese Yen are weakening. Emerging market and commodities currencies are facing downward pressure, and we are seeing increasing volatilities in international capital flow. This complex situation is posing new challenges. As China is maintaining a relatively large trade surplus, RMB’s real effective exchange rate is relatively strong, which is not entirely consistent with market expectation. Therefore, it is a good time to improve quotation of the RMB central parity to make it more consistent with the needs of market development.

Since the reform of the foreign exchange rate formation mechanism in 2005, the RMB central parity, which serves as the benchmark of China’s exchange rate, has played an important role in market expectation and stabilizing RMB exchange rate. Recently, however, the central parity of RMB has deviated from the market rate to a large extent and with a larger duration, which, to some extent, has undermined the market benchmark status and the authority of the central parity. Currently, the foreign exchange market is developing in a sound manner, and market participants are increasingly strengthening their pricing and risk management capacities. The market expectation of RMB exchange rate is diverging, and the preconditions for improving quotation of the RMB central parity are becoming mature. Improving the market makers’ quotation will help enhance the market-orientation of RMB central parity, enlarging the operation room of market rate and enabling the exchange rate to play a key role in adjusting foreign exchange demand and supply.

What is next for China’s exchange rate reform?  The PBOC’s spokesman said:

Next, the reform of RMB exchange rate formation mechanism will continued to be pushed forward with a market orientation. Market will play a bigger role in exchange rate determination to facilitate the balancing of international payments. Foreign exchange market development will be accelerated and foreign exchange products will be enriched. In addition, the PBC will push forward the opening-up of the foreign exchange market, extending FX trading hours, introducing qualified foreign institutions and promoting the formation of a single exchange rate in both on-shore and off-shore markets. Based on the developing condition of foreign exchange market and the macroeconomic and financial, the PBC will enhance the flexibility of RMB exchange rate in both directions and keep the exchange rate basically stable at an adaptive and equilibrium level, enabling the market rate to play its role environment, retiring from the routine FX intervention, and improving the managed floating exchange rate regime based on market demand and supply.

Currently, under the complex international economic and financial condition, we are seeing increasingly large and volatile cross-border capital flow. As such, the PBC and SAFE will strengthen the examination of banks’ FX transactions according to relevant laws and regulations, adopt effective measures to fight money laundering, terrorist financing and tax evasion activities, and improve the monitoring of suspicious cross-border capital flow. The PBC and SAFE will severely punish illegal FX transactions, including underground banks, and maintain a compliant and orderly capital flow.

Following the devaluation by China’s Central Bank, The Wall Street Journal cautioned that:

The engineered fall in the yuan is likely to cause political ripples around the world. In particular it may reignite criticism of China’s tight control over the yuan’s exchange rate within the U.S. Congress and some American businesses, which have long said the currency was already too weak and set at a rate that allowed Chinese exporters to sell their goods artificially cheap on world markets.

As recently as April other central bankers were speaking confidently that China wouldn’t devalue. This puts pressure on them to follow suit.

The Guardian cautioned that China’s decision to devalue its currency could trigger “copycat devaluations” by Central Banks across the region, as such countries are attempting to maintain their own competitiveness against China.

The move by the PBOC comes as a slowdown in China deepens, as data shows that exports fell 8.3 percent from a year earlier in July, which was well below estimates for a 1.5 percent decline.

China’s economic growth in the first quarter (Q1) of 2015 reached the slowest quarterly pace in six years at 7 percent from a year earlier, this was followed by the same growth rate in the second quarter (Q2) which beat economists’ estimates for 6.8 percent growth.

Growth has suffered in China due to a combination of an industrial slowdown, a weak housing market, and local debt, which has added to increased pressure on authorities to do more to meet Premier Li Keqiang’s 2015 growth target of “about 7 percent“.

A full-year growth rate of 7 percent would be its slowest annual rate of expansion in 25 years.