AUGUST 11, 2015 JCOLLINS LEAVE A COMMENT
By JC Collins
There are multiple things going on with the recent announcement from the People’s Bank of China to reduce the daily reference rate of the renminbi against to USD by 1.86%. The most obvious factor which we need to consider is that China is preparing to widen the trading band.
China’s State Council itself announced on July 24th that they would be widening the trading band against the USD from 2% to 3%. So the move yesterday by the PBoC should not be a big surprise when we consider the level of strategy taking place between China and the United States in regards to the multilateral transition.
Back in March I published a post titled When Will China End the Dollar Peg, where we reviewed the process which China will follow on its path to having their currency added to the SDR basket composition. In that piece I stated that China will in fact widen the trading band in the lead up to the SDR decision, or right after. As stated, this was recently confirmed by China’s State Council.
The IMF said last month that the renminbi is now considered to be fairly valued. The United States has been vocal about China’s currency not being liberalized enough and more market oriented. The move by the PBoC both addresses the US concern and in fact allows the RMB to be more market oriented.
But that is not the end game with this mov
Understanding the trading band between the RMB and USD is vital to understanding what is taking place here. The daily reference rate which acts as an RMB peg to the USD, or otherwise referred to as the midpoint rate, defines the middle of the trading band.
Currently the trading band is set at 2%, which was increased last year from 1% to 2%. This band allows the RMB to rise or fall 2% from the midpoint rate which is established by the PBoC. For clarity, the yuan can fall 2% below the trading band or it can rise 2% above the trading band.
A cut in the midpoint rate of 1.86% will still allow the yuan to rise and fall by 2% within the band. If it rises the full 2% above the midpoint rate than the cut accomplished very little from a straight forward perspective.
But it also allows the yuan to depreciate the 2% below the midpoint rate as well, which is lower than it was before the change.
Some fundamentals at play here need to be addressed. There is the logical and linear strategy of currency depreciation as a form of economic warfare. This is the much discussed currency wars which are believed to be somewhat random and reactionary. I propose that nothing happening in the monetary system today is reactionary. It is all a well thought-out strategy.
In this fashion, it is being reported that now India, Russia, and Thailand, are considering a rate cut to their domestic currency. This play will increase the exchange rate volatility which we have stated here over and over will increase pressure on the dollar denominated monetary framework.
At this point of the transition, the rate cuts but China, and any other ones that follow, will hurt the USD more. Like the yuan, the initial response is a depreciation of the currency pegged against the USD, but this will only amplify the systemic imbalances in the USD denominated framework.
Using the Chinese move as our reference point, a further depreciation of the yuan against the dollar will increase exports out of China. As long as the USD remains as the global reserve currency this increase in Chinese exports will further increase America’s trade deficit, putting even more international and domestic pressure on the dollar.
This increasing pressure on the USD in the lead up months to the RMB being added to the SDR basket will acts as a sort of elastic when the Special Drawing Right composition finally changes and international confidence in the RMB as a reserve currency expands.
At this point, the capital outflows from USD denominated instruments into RMB denominated instruments will increase and will help manufacture the massive amount of demand required to shift away from using the dollar as the primary reserve asset and begin implementing the SDR in its place.
The USD will begin to experience depreciation at this point against other currencies and the use of substitution accounts to exchange dollar denominated foreign reserves will commence.
Keep in mind that it is US Treasury policy that a strong dollar hurts the American economy. China’s move to weaken the yuan against the dollar, though only temporary, is in fact a huge response to America’s resistance to reforming the international monetary framework.
This reduction in the daily midpoint rate is allowing for an increase in pressure on the USD in the lead up to the SDR decision, which will be made in China’s favor. The kneejerk reactions stating this rate cut will hurt China’s chances of having the yuan added to the SDR do not consider the balance of payments deficits and broader macroeconomic need for a multilateral framework.
The interest rate increase which the Federal Reserve will announce soon will create further pressure on the USD and USD denominated instruments. The action by China, and the coming action by the Fed, will both work together towards the multilateral transition. The margin of fluctuation is found in how much each currency will depreciate or appreciate, and the time it will take to do so.
Perhaps China likes having a huge trade surplus and would like the keep RMB appreciation under control to maintain that surplus. America needs to lower its trade deficit, but this will not happen as long as China maintains its trade surplus. The need for the US to remove the dollar as the reserve currency is directly related to this imbalance between payments.
I would suspect that the Fed rate increase is being delayed in attempts to manoeuver around the outside of a Chinese currency depreciation. Regardless, the Fed cannot wait much longer to take action on the appreciating dollar, and when it does, China will be sure to widen the trading band of the RMB against the USD within days of the Fed announcement.
Chinese policy makers understand that they cannot have their cake and eat it too. At some point they will have to allow the RMB to appreciate against other currencies in order to reduce its exports and trade surplus. This is the main reason why they are planning the transition from a trade exporting economic model to a trade services economic model.
What this means is that China will be exporting RMB denominated instruments as a form of trade, and less cheap goods. This move on reducing the midpoint rate is temporary and will eventually lead to the appreciation of the yuan. Eventually the band will not only expand to 3% or possibly 4%, but it will in fact be ended and the RMB will be allowed to free float. It’s inclusion into the SDR basket will facilitate this ending of the managed peg. Now would be a good time to invest in the Chinese currency.
The implementation of a new SDR composition which includes the RMB could work on a sliding scale type valuation. The initial inclusion of the RMB could still be pegged to the USD with a widened trading band, such as 4%. This could be reviewed bi-annually, or annually, with the trading band widened by 2% increments after each assessment. Over a period of time this incremental widening of the RMB trading band will stabilize the exchange rates between both currencies and the appreciation and depreciation expectations can be balanced without causing increased systemic risk and volatility.
Considered in that light, the recent reduction in the midpoint rate of the band by the PBoC is a direct shot at the US. It’s telling American policy makers that the longer you delay acting on reforming the international monetary framework, the harder and longer we are going to make it for you to climb out of your trade deficit and depreciate your currency to where you need it to be. – JC
