The People's Bank of China (PBOC) moved its daily CNY/USD reference rate down for two consecutive days on 11 and 12 August. The 1.9% move which resulted on 11 August marked the largest one-day devaluation since 1993. The cumulative depreciation over 11-12 August was 2.8%.
The CNY/USD exchange rate is controlled, with daily moves limited to within 2% of a central fixing rate set by the PBOC. The PBOC has presented the move as technical and operational in nature, highlighting that the market rate had deviated consistently from the central fix for several months and that the move would help push it closer to the market equilibrium. The change helps meet the IMF's criteria for including the renminbi in the basket making up the SDR (special drawing rights), where a five-yearly decision is expected from the IMF's Executive Board in October or November this year.
However, it is difficult to separate the depreciation entirely from weak activity data for July - particularly exports and fixed-asset investment - and from broader concerns over growth. It may be possible for the PBOC to describe the development as technical, while the direction of movement of the currency highlights wider pressures on the economy.
The depreciation is limited so far compared with some other large emerging markets - Brazil's and Russia's currencies have depreciated by 35% and 45% versus the US dollar over the past year. It should also be seen in the context of the appreciation of China's nominal effective exchange rate (NEER), which has appreciated by 3.6% year-to-date. By comparison, Korea's NEER appreciated by 2.1% while Japan's depreciated by 1.1% over the same period. As such the depreciation so far seems modest and broadly consistent with the unchanged monetary policy stance announced by the PBOC in its monetary policy report on 7 August.
Changes in the method for setting the CNY/USD exchange rate are in line with other steps to liberalise key areas of the country's capital markets. Recently, this has also included the change to allow banks to issue large-denomination certificates of deposits at unregulated deposit rates since June 2015. The evidence suggests the authorities have acquiesced in the movement of large sums of capital since 4Q14.
However, allowing market forces freer play implies higher volatility and uncertainty. By keeping the nominal exchange rate more stable until August 11, the authorities had to allow foreign-exchange reserves to absorb the pressure that had emerged on the external accounts. China's foreign reserves have fallen from an all-time high of USD3.99tn at end-June 2014 to USD3.65tn as of end-July 2015. The decline is not yet a negative factor from an external liquidity standpoint, as the reserve stockpile clearly remains immense. However, it has added to the challenge of managing macroeconomic policy by destroying liquidity in the domestic financial system, blunting the broader easing of monetary policy that began in earnest last November.
The authorities' aggressively interventionist response to the bursting of a bubble in equities in July shows that there are still limits to allowing market forces more scope. Allowing more market-driven volatility may seem counter-intuitive while the Chinese economy struggles to overcome the structural weaknesses that have built up in the phase of debt-driven, investment-heavy growth, including the likelihood of widespread debt problems in the corporate and local-government sectors. However, market forces are likely to be an essential part of the solution to these problems - by helping to allocate resources more efficiently, and highlight where the problems are concentrated.
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A more substantial devaluation of the yuan, if it emerges against Fitch's expectation, would add to the economic challenges currently being faced by Asia-Pacific more broadly. It could potentially broaden the impact from China's now-expiring real estate boom for those economies that are more exposed to Chinese consumption - including major commodity exporters such as Australia and Indonesia. It could also see more "onshoring" of activity back into China and dash some of the hopes of some economies to pick up some of the manufacturing investment that was starting to find China too expensive.
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