What China’s New Currency Fix Means

The Chinese currency looks set for a new era of volatility after the recent move by mainland authorities to devalue the Renminbi. Although the initial adjustment on August 11 left the RMB just 1.9 percent lower, it sent global markets into a tailspin as it ended a decade of appreciation against the dollar.

Investors have been playing catch-up as they digest the surprise move after the People’s Bank of China said it would now adopt a new RMB fixing mechanism that is more aligned with supply and demand.

On the one hand, the adoption of a more market-driven exchange rate is positive as it takes China further down the road of RMB internationalization and deregulation of its capital account. The shift also appears to help China satisfy conditions set by the International Monetary Fund to qualify the RMB for its “special drawing rights” basket.

But at the same time, the departure from a policy-driven, de facto peg to the dollar introduces new risks to China-related investment. Both investors and businesses trading in RMB now have to manage currency volatility and policy uncertainty. To understand the significance of this policy shift, we sat down with Ravi Pandit, Executive Director of Foreign Exchange and Interest Rate Products for Asia Pacific at CME Group.


Previously China has operated a closed capital account while setting the RMB within a fairly tight peg to the U.S. dollar.  How big a departure do you expect this new fixing regime to be?

It appears there has been a consensus decision by mainland authorities to move on monetary policy and also liberalize the exchange rate. While there is an element of a market-driven fix in the new regime, the move also appears to have been driven by domestic monetary policy needs. Pressure has been building to weaken the RMB as China has been running down its foreign exchange reserves in order to support its currency peg, which has in turn meant it has been tightening monetary policy. This has been creating tensions as the government is seeking to achieve its committed 7 percent GDP growth target.


If this move is partially driven by monetary policy, do you expect China to continue with more easing?

Yes. One reason authorities have been intervening in foreign exchange markets is because of capital outflows, which reduce domestic liquidity. China does have the ammunition to do this and to manage the adjustment process given it still has some $3.6 trillion of foreign exchange reserves. We have seen cuts in both interest rates and reserve ratio requirements since the RMB depreciation and more easing is expected to counter the intervention to slow the weakening of the RMB due to outflows.


RMB volatility has already picked up significantly. How is this going to impact the investment appeal of the RMB given it has previously been perceived as a safe haven, policy supported currency?

There has clearly been some selling of RMB based on this move because there was a significant carry-trade into CNH, which was funded in Dollars, Euro and the Yen. We see this as more a knee-jerk reaction, however, rather than being driven by fundamentals.  Our longer-term view is that RMB usage and demand will continue to grow due to the sheer size of China’s underlying economy and its importance as a payments currency. Even while operating with currency controls, the RMB has already broken into the top five as a world payments currency.


Has the new fix led to a convergence between the onshore and offshore RMB markets?

So far, as well as seeing more volatility, the gap between the onshore CNY and offshore CNH has actually widened. The spread between USD/CNY and USD/CNH which was trading at under 100 points (USD/CNH 0.0100 higher than USD/CNY) before Aug 11, jumped to around 630 points after the devaluation on Aug 11, and traded as high as around 980 points subsequently on Aug 25. The widening spread with the CNH trading weaker than the onshore market, indicates that the freely traded offshore market expects more weakness ahead for the CNY and the possibility of some ongoing intervention in the onshore markets.


How do you expect the move in the RMB to impact other regional currencies?

In some ways the RMB weakening is only catching up with moves by other Asian currencies. For example, the Malaysian ringgit has lost 19 percnet of its value since the beginning of May and the Indonesian rupiah has fallen 8 percent.  The Australian dollar is an interesting case as it typically trades as a China proxy given its commodity exposure. Since the end of June, we have witnessed record open interest in Australian dollar futures, which coincided with the initial Chinese stock market correction that led to subsequent government intervention in domestic stock and currency markets.


What are you seeing in terms of interest in trading RMB following the recent depreciation?

Volatility in RMB can lead to increased trading volumes, although we cannot tell if there is more activity related to directional trades or simply hedging strategies. At the same time, the fall in the RMB has led to renewed weakness in commodities so this volatility has also led to increased futures and options trading activity, with overall FX at CME Group in August up 33 percent on the same period last year .


Do you believe the weaker RMB and capital outflows will have any impact on China’s commitment to internationalize the RMB and open up its capital account?

Most evidence suggests China is committed to increasing two-way capital flows. However, in order to open up the capital account, China first needs to further liberalize its domestic fixed income and money markets. This is a process that will require a series of steps over time.


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