By Michael Stanes, Investment Director at Heartwood Investment Management
Most market participants, including ourselves, were surprised by the People’s Bank of China’s (PBOC) policy action on the renminbi currency. Many attribute this latest policy action as a tool to help Chinese external demand.
We would counter that if the authorities wanted to enter into a ‘global currency war’, then they could have gone much further and lowered the reference rate more substantially. Placing the move into context, the near 2% renminbi adjustment was relatively modest relative to the 12% appreciable rise in the real effective exchange rate over the past 12 months through to June, 2015. To have a substantive beneficial impact on trade, the renminbi would need to see rapid depreciation, a scenario that the authorities would probably be unwilling to allow, given the risk of triggering sharp capital outflows, which would potentially create more instability in financial markets and the economy.
The more likely reason underlining the PBOC’s decision is the renminbi’s inclusion as a global reserve currency in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR). Many investors expected that the authorities would await the outcome of the IMF’s decision on whether to include the renminbi, which has been very stable over the last few months.
However, the IMF announced in early August that it needs to see more currency flexibility and has subsequently proposed delaying its decision on the renminbi’s inclusion in SDR until September 2016. Clearly, coming so soon after the IMF’s judgement, the PBOC’s action can be viewed as a reactive policy response.
The timing of the currency adjustment is not particularly helpful from the perspectives of global growth, inflation and the impact on other emerging market and commodity-related currencies. It may also have implications for Federal Reserve policy, although this is perhaps a marginal consideration given policymakers’ overwhelming focus on the domestic economy.
The PBOC will have to delicately manage the implications of last week’s decision as it seeks to rebalance China’s economy, as well as contain any potential flight of capital.
While acknowledging there are multiple risks, we expect those risks to be carefully managed as the Chinese authorities ensure a gradual depreciation of the currency over the coming months. Reassuringly, PBOC officials have sought to assuage the market’s concerns in a rare press briefing by implicitly suggesting that the renminbi should not weaken significantly and deviate from the fundamentals. In our view, the best case scenario would be for the PBOC to announce further stimulus measures and/or policy guidance over the next few weeks.
Longer-term, the Chinese authorities are taking important steps towards a free-float currency. We view the PBOC’s move as part of a strategic objective to ensure that China becomes a fully recognised member of the global financial system. It is early days, but we do not consider this policy move to presage a substantial devaluation of the Chinese currency. We think the markets have overreacted to the move and developments might even afford opportunities in currency and financial markets most exposed to the renminbi’s performance.