Blog Post

The aging dollar peg: time for the PBC to bid it farewell

The Chinese renminbi (RMB) depreciated 2.5 percent against the US dollar in 2014. This was the first depreciation since 2005, when Beijing timidly started loosening its tight dollar peg. Recently, the RMB has repeatedly tested the weak side of its daily trading band, despite attempts by the People’s Bank of China (PBC) to signal its preference for a steadier bilateral RMB-USD rate via its daily fixing (Figure 1, left panel). What has led to the changing fortunes of the RMB? What lies ahead for the currency in 2015?

By: Date: February 19, 2015 Topic: Global Economics & Governance

The Chinese renminbi (RMB) depreciated 2.5 percent against the US dollar in 2014. This was the first depreciation since 2005, when Beijing timidly started loosening its tight dollar peg. Recently, the RMB has repeatedly tested the weak side of its daily trading band, despite attempts by the People’s Bank of China (PBC) to signal its preference for a steadier bilateral RMB-USD rate via its daily fixing (Figure 1, left panel). What has led to the changing fortunes of the RMB? What lies ahead for the currency in 2015?

I can think of several possible factors leading to the most recent bout of weakness in the bilateral RMB-USD exchange rate. 

The most obvious culprit is the broad strength of the US dollar (Figure 1, right panel). For instance, since start-2014, the euro and yen have weakened by 15 percent against the dollar, respectively. Consequently, the Chinese ‘redback’ has also weakened slightly against the almighty American ‘greenback’, though the RMB is still outperforming most other major and emerging market currencies. According to BIS statistics, the RMB gained some 7 percent in effective terms in 2014 and has remained one of the few strong currencies globally. 

The second and related factor is the monetary policy divergence between China and the US. Whereas the US Fed is expected to start raising its policy rate and has already stopped further unconventional (net) bond buying, the PBC has embarked on a cycle of monetary easing. Hence the anticipated interest rate differential between the two currencies is narrowing. 

There are now questions about whether the RMB is already fairly valued or even somewhat overvalued.

The third factor concerns the underlying currency valuation. Over the past decade, the RMB has gained 50 percent on a broad real effective basis, a strength few major advanced or emerging market currencies can match. Even allowing for fast Chinese productivity growth, there are now questions about whether the RMB is already fairly valued or even somewhat overvalued. Simply put, the once broad-based market consensus of an undervalued RMB is gone, after its massive cumulative appreciation. 

Fourth, more market participants are becoming worried about signs of increased stress in the Chinese financial system. As the exchange rate is one of the most important financial asset prices, how can one expect an ever-stronger RMB on top of a more fragile Chinese financial sector? It makes little sense to dread Chinese shadow banking and to preach meaningful RMB appreciation at the same time.

Finally, the PBC appears to have taken a more hands-off approach towards managing the RMB. Since early 2014, it has intervened less in the FX market and widened the daily trading band. But it has also occasionally stepped in to restore market functioning, disrupting carry trade and successfully injecting some 2-way volatility. A growing offshore RMB market in Hong Kong also adds to its interactions with the onshore RMB market, with risk sentiment possibly playing a bigger role in RMB exchange rate dynamics. We estimate the offshore RMB turnover to have more than doubled in the past two years. 

The PBC appears to have taken a more hands-off approach towards managing the RMB.

Hence a mighty US dollar, monetary policy divergence, currency valuation concerns, and less PBC intervention all combine to sway currency expectations, raise volatility and narrow interest rate differentials. Thus the implied Sharpe ratio declines, prompting an increase in Chinese corporate hedging of dollar liabilities, with rising dollar deposits and a more rapid extinguishing of Chinese corporate dollar debts, estimated at more than US$1trillion in 2014. Added to Chinese demand for US dollars have been the growing overseas acquisitions by Chinese companies. 

In balance-of-payments terms, the fourth quarter of 2014 saw the largest Chinese capital outflow in 16 years, and official foreign exchange reserves have fallen steadily since mid-2014, though this is in part due to valuation effects. In short, demand for US dollars by Chinese residents has risen, weakening the RMB-USD exchange rate.

What will happen next? It depends a lot on how the PBC will respond to Chinese corporate dollar buying. I envision three possibilities. 

First, the PBC could cling more tightly to the dollar peg in ‘stormy weather’, just like it did in the 2008 Global Financial Crisis and the 1998 Asian Financial Crisis. The result will be a heavy deflationary blow to the Chinese economy in an environment of persistent dollar strength, a PBC put on the RMB firmly instilled into market expectations and some brief sense of stability. In this case, the looser dollar peg could tighten again. 

Second, the PBC could take a ‘laissez faire’ approach, completely stepping back from the currency market to let it clear itself, perhaps in a wider trading band. This would result in sharp volatility and even some corporate stress unless capital controls were tightened considerably. In this case, the loose dollar peg could vanish fast. 

A third and more likely scenario would be for the PBC to let the RMB move more freely against the dollar but prepare to lean against the wind by selling dollars out of its official reserves from time to time while keeping a watchful eye on cross-border capital flows. In this case, the loose dollar peg would start fading gradually.

This last approach makes sense for a number of reasons. In the short term, it would help deliver a warranted Chinese monetary easing by helping stabilise the effective exchange rate and an orderly unwinding of the Chinese corporate carry trade. In the longer term, it would help enhance two-way currency flexibility ahead of fuller interest rate deregulation and greater capital account liberalisation. 

The 20-year old but increasingly loose dollar peg has served the Chinese economy well as a simple nominal anchor, but its time is up.

This 20-year old but increasingly loose dollar peg has served the Chinese economy well as a simple nominal anchor, but its time is up. First, as the biggest trading nation and second largest economy on earth, China is simply too big to be anchored to any single currency, even in a loose fashion. Second, a much more flexible RMB is needed before full interest rate liberalisation and substantial capital opening. Third, a dollar peg has often amplified external shocks to the Chinese economy rather than absorbing them, in part because of the dollar’s safe haven role. Finally, the US no longer welcomes a renewed Chinese peg to its currency and yet demands nothing but ‘one-direction flexibility’.

It’s high time the PBC starts seriously letting the aging dollar peg go.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Opinion

La lunga marcia della Cina sui porti europei

I porti sono una risorsa vitale per l'economia europea: oltre il 70% delle merci che attraversano le frontiere europee viaggiano via mare. L'anno scorso, il presidente della Commissione europea ha proposto di istituire un nuovo meccanismo europeo per la verifica degli investimenti esteri diretti tra le crescenti preoccupazioni sull'acquisizione di infrastrutture europee e attività ritenute strategiche dall'estero. Alla luce di questi sviluppi, riteniamo che sia utile concentrarsi sul crescente coinvolgimento della Cina nel sistema portuale europeo.

By: Simone Tagliapietra Topic: Global Economics & Governance Date: July 20, 2018
Read article More on this topic More by this author

Opinion

Can Multilateralism Adapt?

Global governance requires rules, because flexibility and goodwill alone cannot tackle the hardest shared problems. With multilateralism under attack, the narrow path ahead is to determine, on a case-by-case basis, the minimum requirements of effective collective action, and to forge agreement on reforms that fulfill these conditions.

By: Jean Pisani-Ferry Topic: Global Economics & Governance Date: July 3, 2018
Read article More on this topic More by this author

Blog Post

US tariffs and China's holding of Treasuries

China has the biggest bilateral trade surplus vis-à-vis the US but is also a top holder of US government bonds. While China has started to counteract US trade tariffs, economists have been discussing the case of China acting on its holdings of US Treasuries. We review recent contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: July 2, 2018
Read about event More on this topic

Past Event

Past Event

Trade war trinity: analysis of global consequences

Analysis of the long-term impact of the trade war and its three key players: EU, US, and China.

Speakers: Alicia García-Herrero, Ignasi Guardans and Carl B Hamilton Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 28, 2018
Read article More on this topic

Blog Post

China’s strategic investments in Europe: The case of maritime ports

The EU is currently working on a new framework for screening foreign direct investments (FDI). Maritime ports represent the cornerstone of the EU trade infrastructure, as 70% of goods crossing European borders travel by sea. This blog post seeks to inform this debate by looking at recent Chinese involvement in EU ports.

By: Shivali Pandya and Simone Tagliapietra Topic: Global Economics & Governance Date: June 27, 2018
Read article More on this topic

Blog Post

The G7 is dead, long live the G7

The summit in Charlevoix left behind a Group of Seven in complete disarray. The authors think that the G-group, in its current formulation, no longer has a reason to exist, and it should be replaced with a more representative group of countries. In this fast-changing world, is the G7 only a relic of the past?

By: Jim O‘Neill and Alessio Terzi Topic: Global Economics & Governance Date: June 13, 2018
Read article Download PDF More on this topic

Working Paper

European and Chinese trade competition in third markets: the case of Latin America

While Europe continues to hold important trade powers, the rise of China in the global economy has significantly reshaped international trade and competition. In this paper, the authors show that the degree of competition between both powers in Latin America has risen in the past decade due to China's increased trade of high-quality products. They address whether China is an increasingly relevant competitor for Europe in Latin America and in which sectors China-EU competition is fiercer. These findings should be a wake-up call to Europe in its quest to remain competitive at the global level.

By: Alicia García-Herrero, Thibault Marbach and Jianwei Xu Topic: Global Economics & Governance Date: June 7, 2018
Read article More on this topic More by this author

Blog Post

China’s new role in the global economy

The changing role of China in the world economy has recently been highlighted by its registering of a first current account deficit in 17 years. We review the economists’ analyses of this new role and associated challenges.

By: Nicolas Moës Topic: Global Economics & Governance Date: May 28, 2018
Read about event

Past Event

Past Event

Where is China’s financial system heading? Implications for Europe

How ready is China for the transformation of its financial system and how will this effect Europe?

Speakers: Elena Flores, Alicia García-Herrero, Gene Ma, Hu Yuwei and Guntram B. Wolff Topic: Finance & Financial Regulation, Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 25, 2018
Read article Download PDF More on this topic

Working Paper

How big is China’s digital economy?

The rise of influential Chinese digital giants, including Baidu, Alibaba, Tencent and Xiaomi has shown the world that China is a global leader in digital innovation and it is not surprising that China has started to influence the global digital market. But is China exploiting its full potential in this area? To answer this question, the authors assess how big China’s digital economy is relative to the rest of its economy, and how China performs compared to the rest of the world.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: May 17, 2018
Read article More on this topic More by this author

Blog Post

Trade war: How tensions have risen between China, the EU and the US

The multilateral trading system has been challenged by unilateralist measures and subsequent threats of retaliation. We collect the main events that have shaped the current situation and show which trade flows have been and will potentially be affected by the various measures. We end by discussing possible scenarios moving forward for the EU.

By: Francesco Chiacchio Topic: Global Economics & Governance Date: May 15, 2018
Read article

Opinion

China’s financial opening: Will it be different this time?

It is hard to judge whether China will indeed carry out a substantial opening of its financial sector, despite the significant external pressure it faces from countries such as the United States to liberalise its economy.

By: Alicia García-Herrero and Gary Ng Topic: Finance & Financial Regulation, Global Economics & Governance Date: May 9, 2018
Load more posts