How China’s Exchange Rate Regime Works

Article & Review by GlobalMacroForex

The PBoC (China’s Central Bank) has undergone many changes recently in how they manage the renminbi’s value against other currencies.

Original Trading Band

The PBoC initially set up a peg to the US Dollar through a trading band which specifies a maximum and minimum value that the yuan can trade against the USD.  This picture from the Wall Street Journal illustrates the band:

The PBoC would use its USD reserves to buy yuan if the yuan depreciated out of the band or print yuan and buy more USD reserves if the yuan appreciated out of the band.  The trading range was expanded from .5% to 1%, and then to 2.5%. 

The United States kept pressuring Beijing to abandon the trading band and let the yuan appreciate.  (If left to free market forces, the yuan would appreciate as Chinese workers rapidly grow out of socialism.)  However, Washington’s stance was rather odd given that the Chinese reserves were being invested in US Treasuries.  The US government was only able to borrow so cheaply because the Chinese were running trade surpluses with the USD.

In addition, common sense dictates that if Chinese corporations wanted to sell Americans goods for an artificially cheap price, then America should let them do so.  It would prop up the US standard of living, and the US savings could be spent on other things that would create different jobs for Americans.  However Washington DC isn’t accusing Beijing of currency manipulation for actual economic reasons; it’s because of political pressure from US exporters.  By robbing the US consumers of purchasing power, Washington seeks to stimulate exports.

New Basket Target

The United States and the IMF kept pressuring the Chinese to let its currency be more influenced by free market forces with the goal of allowing the RMB to appreciate.  In 2014 the Chinese construction credit bubble cracked somewhat, and the RMB plus its equity markets dropped in value.  In March 2014, the trading band was expanded from 1% to 2%, and to counteract the drop, the Chinese spent a massive amount of their USD reserves on propping up the RMB’s exchange rate.

This chart from Eswar Prasad’s Gaining Currency shows the PBoC’s foreign exchange reserves (which are mostly in USD) suffering heavy drops trying to defend the RMB starting in late 2014 into 2015/2016.

However, as this chart from Euromoney magazine shows, the renminbi was still testing the limits of the trading band even in 2015.

On December 11, 2015, the Chinese government announced it would transition to a basket based system with more influence from the free market.  This is exactly what Washington had requested of them.  However, ironically the Chinese government decided to do it at a time when the RMB was falling in the foreign exchange markets, working against America’s interests.  [Source: Prasad] In other words, the free market normally would push the value of the yuan higher than the RMB/USD trading band allows, so the Chinese government would need to print RMB to depress the value.  Now instead the RMB was falling in value below what the trading band would allow, and the Chinese government normally would be obligated to keep using USD reserves to prop up the value.  Instead, the Chinese allowed this depreciation (against Washington’s wishes) by throwing their hands in the air and insisting on relying on the “forces of the free market.”

Beijing announced it would transition to managing the RMB against a basket of currencies including the USD, Euro, Yen, and many others.  They did not say what this basket would be at first.  However as time progressed, in an attempt to be more open, the list has been published.

By being so open about its list, Chinese authorities seeked to avoid criticism of currency manipulation from the Trump administration.  In addition, they hoped this move would transition the renminbi into a larger more international role and reduce their reliance on American demand.  Will this internationalization strategy work? 

Let’s learn more in my next article on the difference between China’s onshore and offshore renminbi.