The move by People’s Bank of China’s (PBoC) this week to loosen the renminbi (RMB) exchange rate, inducing a depreciation of the RMB against the US dollar by 3.5% in two days, has sparked intense debate among economists, pundits and policymakers.
Does the depreciation show the People’s Republic of China (PRC) is moving against or towards market forces?
My view is that the exchange rate was overvalued before the policy change, and therefore the recent move is in the direction consistent with the fundamentals. In fact, back in March 2015 I said in a press release that the Chinese exchange rate had been overvalued compared to market fundamentals, which had reduced PRC competitiveness and contributed unnecessarily to a slowdown in growth.
The developments of the last few days not only meet our previous expectations, they also are moving in the direction of supply and demand. The exchange rate of the RMB since the beginning of the year (see Chart 1) shows clearly that the onshore rate (the rate determined by the PBoC) has depreciated less than the offshore (or market rate).
Moreover, when the authorities were intervening in the currency market, until a few days ago they were mostly selling the US dollar to prevent the RMB from depreciating. This can be seen clearly from the steady loss of the foreign exchange reserve in spite of a persistent trade surplus (Charts 2 and 3).
Moreover, when one looks at the longer term trend (Chart 4) it’s clear that the moves this week are small scale depreciation compared to the broader, more persistent, and more significant appreciation of the RMB since 2004. If the Chinese authorities choose to let market forces play a decisive role in determining the future value of the currency, this will be regarded as a very positive move.
Will the exchange rate change reverse PRC’s growth slow-down?
No, this exchange rate change will not play a major role. The most important reasons for PRC’s growth slowdown are mostly structural. Two factors in particular have played a dominant role: PRC’s shrinking labor force and a considerable rise in real wages since 2008 or so. At the same time, many other countries with a lower wage than PRC have been working on improving their infrastructure or engaging in other reforms to make themselves more competitive in the international market. These factors are the primary reasons for PRC’s growth slowdown and cannot be reversed by exchange rate changes. Reducing overvaluation of the RMB is a welcome change that eliminates one source of unnecessary self-inflicted pain.
What other policies can help lift growth in PRC?
The answer is yes. Many of the reform items in the government’s 2013 reform agenda could help improve the economy’s aggregate productivity. In addition, a tax reform that reduces the social security tax on firms and makes the tax rates lower and more uniform can also raise productivity and spur investment. Tax rates in PRC remain too high, leaving considerable scope for rationalization. Employer pension contributions are but one example. These are the kind of policy changes that simultaneously are pro-growth and respond to PRC’s structural bottlenecks.
Will the PBoC’s decision help or hurt the renminbi’s chances of becoming a reserve currency in the Special Drawing Rights (SDR) basket?
PRC has a strong interest in seeing the renminbi become a member of the SDR basket. Virtually any economic policy decisions by PBoC related to currency and the financial sector should be viewed through this lens. If exchange rate determination from now on truly allows the market to play a more decisive role, then the recent exchange rate move would be regarded as pro-market and consistent with what one would expect from currencies in the SDR market. So the answer depends as much on what PBoC will do in the next few months as what it did in the last few days.
Will the renminbi’s depreciation hurt other countries?
Even though the move is to make the exchange rate closer to market fundamentals, it is still depreciation. There is no question that for countries that compete directly with PRC, this will hurt their competitiveness. But, it’s important to keep in mind that many countries in the world, especially in Northeast and Southeast Asia, are integrated with PRC through regional and global value chains. This means that some of their value added exports to major markets like Europe and the US are done indirectly through PRC. That is, they first export to PRC components and parts. Manufacturers in PRC then input their own components and value added and export them to the rest of the world. In that context, whatever is helpful to PRC’s exports is also helpful to other exporters linked to PRC. As important, as the overall extent of depreciation is still small, the quantitative impact of the exchange rate move is not likely to be big either unless it is the beginning of a larger and more persistent series of depreciation.
This article was first published by the Asian Development Bank (www.adb.org)