Fed can’t ignore Beijing’s decisions

China devalues – the Fed can’t ignore it

Eric Chaney, head of Research at AXA Investment Managers (AXA IM), discusses the impact of the People’s Bank of China’s (PBoC) surprising moves on currency this week on the timing of the Federal Reserve’s (Fed) rate hike and concludes that the balance of risks has now tipped towards a December hike from AXA IM’s initial September expectation.

The RMB devaluation came as a surprise…

The PBoC took markets and observers by surprise when adjusting the central rate of the CNY down by 1.9% vis-à-vis the US dollar, and announcing that the official fixing will from now on be closer to the market close. As a result, the CNY has fallen further and a 4% to 10% devaluation looks likely now, together with higher volatility.

The timing and the modality of this foreign exchange (FX) policy change came as a surprise – a widening of the trading band had been seen as a smoother way to give more breathing space to the markets. It has stoked up uncertainties about China’s future exchange rate policy as well as the health of the Chinese economy and the competitiveness of its export sector.

Yet, even if the move is a step towards a more flexible exchange rate, one thing remains: China is only changing the design of its currency’s peg to the US dollar, not the principle of a peg. With capital flows across the Chinese border still under tight control and domestic capital markets far from being resilient enough to weather external shocks (as exemplified by the recent stock market crash), the prospect of a truly floating currency remains quite remote.

… but makes economic sense

The market action so far tends to indicate that the RMB/CNY is overvalued and it might well be the case, despite all the complaints, notably in Capitol Hill, of an unfairly valued currency. Although markets tend to focus on the face-value of the RMB against the US dollar, which has been roughly stable since 2012, the key parameter is China’s real exchange rate (adjusted for inflation trends) against a basket of the currencies of the country’s main trading partners.

On this sound economic basis, the RMB has appreciated by 30% since 2010, around half of that since mid-last year. In comparison, the Korean won was up ‘only’ 13%, the US dollar by 10% while the Brazilian real fell by 22% and the Indian rupee by 11%.

The weakness of Chinese exports (down 2% thus far this year, compared to last year) as well as the persistence of very low inflation (1.3% on average since the beginning of the year) also point to a mix of weak external demand, lacklustre export competiveness and deflationary risks, despite a resolutely expansionary monetary policy. Since the PBoC may now take advantage of a fixing closer to the market clearing rate to further depreciate its currency – if market sentiment remains negative – a further depreciation of the RMB appears possible, if not likely.

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