China says: “Oops!…I did it again”

Posted: August 13, 2015 in China, Currencies
Tags: , , , , , ,

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China is being accused of starting a new currency war. The People’s Bank of China has devalued the Chinese currency three times in three days. Politicians on Capitol Hill can barely conceal their ire. There is even talk that both the Fed and Bank of England will hike interest rates as a result. Yet for all that, it may simply be that China is doing what both the IMF and Washington have been calling for it to do for years.

China wants its currency, the yuan, or the renminbi, to be part of the basket of currencies that make-up the IMF’s Special Drawing Rights, or SDR.  For this to happen, the IMF says that the yuan must be allowed to trade freely on the open markets. China say that this is precisely what it is doing.

There was a time when China manipulated its currency, keeping its value artificially low. To achieve this, the government went out and bought western bonds, especially US government bonds. This in turn pushed up on the value of those bonds, causing their yields to fall. It’s an important point that often gets overlooked. Some criticise the Fed’s polices over the years, but truth be told in the long term, it is not central banks which determine interest rates, but movements of money which in turn can be changed by deep forces at play.  China’s policy of maintaining a cheap currency was a major factor in creating low interest rates for much of this century. And while the cheap yuan theoretically led to lower US exports, US borrowing was partly funded by China, and at exceptionally low interest rates.

It is just that the yuan is no longer cheap.  It hasn’t been for some time. If the yuan really was allowed to trade freely, it would surely fall in value. Washington can scream with fury, but China is gradually moving towards a position that the US has wanted it to occupy for years.

After the first devaluation, the IMF said “The new mechanism for determining the central parity of the Renminbi announced by the PBC appears a welcome step as it should allow market forces to have a greater role in determining the exchange rate. The exact impact will depend on how the new mechanism is implemented in practice. Greater exchange rate flexibility is important for China as it strives to give market-forces a decisive role in the economy and is rapidly integrating into global financial markets. We believe that China can, and should, aim to achieve an effectively floating exchange rate system within two to three years. Regarding the ongoing review of the IMF’s SDR basket, the announced change has no direct implications for the criteria used in determining the composition of the basket. Nevertheless, a more market-determined exchange rate would facilitate SDR operations in case the Renminbi were included in the currency basket going forward.”

Some say the timing is cynical, because China has devalued in the same week that saw weak data on industrial production investment and retail sales. That may be right, but so what. China is simply doing what the IMF has recommended, but chosen the most fortuitous moment. What’s wrong with that?

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