This content is the Special Topic included with Treasury's August Monthly Economic Indicator report.
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In August the People’s Bank of China (PBoC) announced changes to the way the value of the renminbi (RMB) or yuan1 (CNY) is set in daily trading and at the same time devalued the currency against the US dollar.
These changes surprised markets and led to speculation about the reasons for them and their implications for China and the rest of the world economy.
This topic looks at the changes, the immediate market reaction to them, and their possible implications, including for New Zealand.
It concludes that, while the changes raise concerns about the strength of China’s economy, they were undertaken primarily to allow markets a greater influence in setting the value of the currency.
Although some further devaluation of the currency may occur, the impact on New Zealand is not expected to be great at this stage.
However, further falls in China’s share market in late August, following July’s volatility, have compounded concerns about the underlying strength of China’s economy.
The yuan appreciated over the past decade...
Since 2005 (apart from October 2008 – June 2010 during the global financial crisis) the PBoC set a daily “fixing rate” for the yuan against the USD. Over that ten year period the yuan appreciated 35% against the US dollar (Figure 1), but by more on a trade-weighted basis recently as the USD appreciated against other currencies, including the New Zealand dollar (NZD).
In nominal trade-weighted terms the yuan rose by around 40% over the past decade2 and by a similar amount against the NZD (Figure 1). It rose by considerably more in real terms as China’s inflation rate was higher than its trading partners’ over that period. Chinese authorities appreciated their currency in response to claims (particularly from the US and IMF) that it was undervalued, giving China’s exports an unfair advantage in world markets. In June this year, the IMF stated that the yuan was close to its equilibrium level.
...but regime liberalised and yuan devalued
In a surprise move on 11 August, the PBoC announced that the daily central rate for the yuan would be set on the basis of the previous day’s closing rate “in conjunction with demand and supply conditions in the foreign exchange market and exchange rate movement of the major currencies.” Previously the PBoC set the central rate around which rates were allowed to vary by plus or minus 2%; that trading band will remain, supported by PBoC intervention if needed.3
At the same time, the PBoC devalued the yuan by changing the central rate from 6.116 CNY per USD the day before to 6.23 CNY, a devaluation of 1.9% and the largest one-day change since market trading began in 1993. The following day and in accordance with the new mechanism, the central fixing rate was increased (i.e. the yuan was devalued) by a further 1.6% to 6.33 CNY per USD, with a further devaluation of 1.1% on 13 August to 6.40 CNY, taking the cumulative devaluation for the three days to more than 4%. The rate has been relatively stable since then (Figure 2 above).
Immediate market reaction was negative...
The change to the foreign exchange regime and devaluation of the yuan followed the release of figures at the end of the previous week showing that China’s exports in July were down 8.3% from a year ago, particularly exports to Japan and Europe. In that context, the immediate financial market reaction to the changes was negative as they were viewed as an acknowledgement of risks to the outlook for China’s economy. International equity markets fell 1-2%, commodity prices and commodity currencies declined (oil prices fell 2- 4% and the NZD fell nearly 1 cent to 65.33 cents US), and bond rates fell (US 10-year Treasuries fell 9 basis points to 2.14%).
A renewed bout of volatility occurred in global financial markets later in the month following a further fall in China’s share market. On 24 August the Chinese share market fell nearly 9% and by 7% on the following day, negating the gains in the first half of 2015 (Figure 3). The falls may have been triggered by a weaker than expected PMI released at the end of the previous week and the lack of an effective response by Chinese authorities to stabilise the stock market.
These developments compounded concerns about the strength of China’s economy and led to falls in equity prices globally, lower commodity prices and commodity currencies (including the NZD and AUD), and further falls in US bond rates. Global markets recovered somewhat over the following days after the PBoC announced further monetary easing (see p.5 above).
...amid speculation about reasons for the changes
There has been considerable speculation about the reasons for the recent changes to China’s currency. At face value, the liberalisation of the regime appears to be aimed at gaining approval for the yuan to be included in the IMF special drawing rights (SDR) basket. Chinese authorities have been pressing for that for some time as it would indicate acceptance of the yuan as a global reserve currency (like the USD). The IMF welcomed the latest changes, but postponed any decision on including the yuan in the SDR basket until later this year, and effective from late 2016.
However, the devaluation of the yuan led many to speculate that the more important reason for the changes was to counteract weakness in the economy by gaining a competitive advantage in export markets. The fall in exports in July tended to support this interpretation and further weak data were anticipated. Other economic data released in August showed a slowing in growth, but not a sharp decline (see p.5 above). There is increasing concern about the accuracy of some Chinese economic statistics and that growth is weaker than reported in official statistics. This view led many to expect further devaluation in the yuan in the days following the changes.
The PBoC’s support for the currency on the second day’s trading under the new regime by intervening to hold up its value suggested that a gradual devaluation was not its main aim. An ongoing devaluation seems unlikely as it could lead to further capital outflows (in anticipation of a weaker currency). It would also not necessarily lead to a gain in competitiveness against other Asian currencies given that most of them fell against the USD when the yuan was devalued.
However, given the dual nature of the changes (liberalisation and devaluation), the reasons for them are likely to include both aspects. The liberalisation of the regime may have been brought forward to coincide with the devaluation on concerns about the weakness of the economy. The devaluation is consistent with the PBoC’s other moves to ease monetary policy to support the economy. The timing of the changes may also have been influenced by the expected tightening of monetary policy by the US Federal Reserve which may lead to further appreciation of the US dollar – and so the yuan – against other currencies.
Impact on China’s economy unclear...
Regardless of the reasons for the changes, their impact on China’s economy is not clear at this stage. So far, the extent of the devaluation of the yuan is less than 5% but it takes it back to its rate against the US dollar four years ago. However, on a trade weighted basis, it reverses only the most recent appreciation of the yuan. The devaluation might be expected to increase China’s competitiveness in export markets, particularly vis-à-vis its Asian competitors.
However, these other currencies also generally fell against the US dollar on the announcement because of the perceived negative impact of China’s devaluation on them, nullifying any gain in the short term. The recent weakness in China’s exports is owing more to weak demand than a lack of competitiveness on China’s part, so the devaluation is likely to have little impact in this regard in the short term. If the yuan continues to depreciate under the new regime, China may gain some competitiveness against its neighbours.
The devaluation of the currency should support traded sectors in the Chinese economy (exports and import substitutes) at the expense of nontraded sectors. However, that would run counter to the authorities’ aim of making the economy more consumption-driven. Any boost to growth should have a flow-on to consumption, though. With weak inflation and producer prices falling for the past three years, there is scope for easier monetary conditions to support the economy.
...as are implications for world economy...
The implications of the changes for the world economy are complex and also uncertain at this stage. Only some of these implications are discussed here. The main impact expected as a result of the devaluation of the currency is weaker commodity demand. China is the major player in many commodity markets and so weaker demand and lower prices were reflected immediately. The currencies of the main commodity-exporting economies (including New Zealand) were also affected immediately.
The changes have come at a time of general weakness in commodity prices as a result of a combination of rapidly increasing supply and weak demand. The CRB Index, a broad-based commodity price index, fell to a 13-year low in the wake of the yuan changes. As well as affecting New Zealand and Australia, weaker commodity demand would affect commodity-exporters in Southeast Asia, such as Indonesia and Malaysia, as well as emerging market economies such as Brazil and South Africa, many of which are already experiencing weak growth.
The devaluation of the yuan is an easing of monetary policy in China and implicitly a tightening of policy elsewhere, so one effect of the fall in the value of the currency could be to increase the need for monetary easing elsewhere or to postpone tightening. The uncertainty created by the move may be a factor in any postponement of the Federal Reserve’s first rate hike; market expectations of an increase in September were scaled back after the yuan changes.
Lower Chinese export prices as a result of the devaluation of its currency could add to global deflationary pressures at a time when many central banks are still aiming to boost demand and inflation in their economies. This reinforces the point above about the impact of the move as an implicit relative tightening of monetary policy elsewhere.
Other possible impacts of the changes are on capital flows. If the yuan continued to depreciate on an ongoing basis it might lead to increased capital outflows from China in anticipation of further depreciation. On the other hand, a weaker Chinese currency may lead to less foreign direct investment from China. There should be no threat to USD-denominated debts as long as long as the fall in the currency is not too great.
...and the New Zealand economy...
The potential impacts of the currency changes on the New Zealand economy are similar to those for other economies discussed above. The main impact is expected to be weaker demand for commodity exports, particularly dairy products. So far the changes in the value of the yuan are less than recent movements in some commodity prices. The net impact on the NZ economy will depend on a number of factors including other influences in global commodity markets and movements in exchange rates.
Given the 20% weight of the yuan in the NZD TWI basket, a fall in the value of the yuan should lead to a rise in the NZD TWI, all else equal. However, the devaluation also led to a fall in the value of commodity currencies (including the NZD) against the USD and most other currencies except other commodity ones (such as the AUD). As a result, the NZD has appreciated slightly against the yuan since its devaluation, but because the NZD has depreciated more against the USD, the NZD TWI has depreciated slightly. However, there are many influences at work on these exchange rates in addition to the devaluation of the yuan, including other developments in China.
The New Zealand economy is also likely to be affected indirectly via Australia. China is a more important goods export market for Australia than for New Zealand and Australia is an equally important export market for New Zealand, so there would be indirect effects via that channel.
...but it may also have wider implications
However, the most important implication of the changes to China’s currency, especially in the short term and when considered in conjunction with the subsequent volatility in the share market, is the concern it raises about the strength of China’s economy and the potentially destabilising impact of the changes on global financial markets at a time when the US Federal Reserve is considering increasing its policy rate. Significantly slower growth in China, at the same time as higher interest rates in the US, would increase uncertainty about the outlook for world growth.
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