News Analysis: China largely succeeds in RMB exchange rate reform over past year

China's authorities have largely succeeded in its objective of revamping the foreign exchange mechanism to make the currency renminbi (RMB) more market-oriented and relative stable to a basket of currencies over the past year, thanks to improved policy communication, U.S. experts have said.

On Aug. 11, 2015, the People's Bank of China (PBOC), the central bank, announced a major improvement to the formation of the RMB's central parity rate against the U.S. dollar, by taking into consideration the closing rate on the inter-bank forex market of the previous day.

The move was described by the PBOC as a "one-time correction" to bridge previously accumulated differences between the central parity rate and the spot market rate, which would make the central parity rate more consistent with the needs of market development.

The central parity rate is the starting point for daily forex trading, and the RMB is allowed to rise or fall by 2 percent from the central parity rate each trading day from March 2014.

Think tank and the International Monetary Fund (IMF) experts agreed that the central bank's move was very much in the direction to increase the role of market forces in the determination of the RMB exchange rate.

But some market participants at that time misinterpreted it as an effort to prop up the economic growth by currency devaluation and incorrectly jumped to the conclusion that China's economy was probably worse than stated. The RMB fell sharply in value in the following days after the reform of the central parity system.

"I think initially when they started changing the system a year ago, they were not good at communication, and there was a lot of confusion in the market about what their intention was," David Dollar, a senior fellow with the Brookings Institution and former official of the World Bank and the U.S. Treasury Department, told Xinhua.

However, Chinese authorities provided "pretty good and clear communication" about its exchange rate policy over the next few weeks and months, Dollar said, citing authorities' arguments that they wanted to have more market forces involved and there was no need for large depreciation of the currency.

Chinese officials have also repeatedly said that China has no intention of devaluating the RMB to gain an advantage in global trade. China has successfully moved up the value chain into higher value-added products and its share of global exports continued to expand in recent years despite the significant appreciation of the RMB, according to Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics and a leading expert on China's economy.

China's current account surplus was about 300 billion dollars last year, which was the largest in the world in absolute terms, indicating that China didn't need to devalue its currency to boost the economic growth, Lardy said.

"China has a large trade surplus, and it's a rapid growing economy, there' s not really the basis for depreciation," echoed Dollar.

But capital outflows from China increased significantly in September and December as market participants expected that the U.S. Federal Reserve would start raising interest rates by the end of the year and the dollar would rise more rapidly against other currencies.

On December 11, China introduced a RMB exchange rate composite index to help guide market participants to shift their focus from the bilateral RMB/USD exchange rate to the effective exchange rate based on a basket of currencies.

The new index, released by China Foreign Exchange Trade System (CFETS), is calculated by comparing RMB to the average value of the 13 foreign currencies, including the U.S. dollar, euro and Japanese yen, weighted according to the trade volume with China.

The PBOC noted that valuing against a basket of currencies does not mean a peg to the basket, but it "will contribute to maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level."

The PBOC also took several other steps, including selling forex reserves, implementing macro prudential regulations and strengthening checks on capital outflows, to help stabilize market expectations for the RMB exchange rate, according to Guan Tao, a senior fellow at the China Finance 40 Forum and former official at China's central bank.

But the large decline in China's forex reserves and rumors about tightening of capital control measures seemed to further fuel market expectations of a weakening RMB at the beginning of this year. China's forex reserves shrank by 512.7 billion dollars in 2015, the largest annual decline on record.

"I think the argument that the decline in reserves is because of panic mainlanders trying to get their money offshore is somewhat misleading," Lardy said. "I think it largely reflects actions of investors and corporations in response to change in exchange rate expectations and interest rate differentials."

The Institute of International Finance (IIF), a global association representing about 500 financial intuitions, also estimated that a large part of capital outflows from China last year were repayments of dollar-denominated debts by Chinese companies, in order to mitigate the impact of the dollar appreciation.

In an interview with Chinese magazine Caixin in February, Zhou Xiaochuan, governor of the PBOC, chose a critical moment to clarify China' s exchange rate policy, as Chinese financial markets prepared to reopen after the week-long Lunar New Year holiday.

Zhou reiterated that China will "rely further on the market to decide the level of the currency and to achieve a more flexible foreign exchange rate" . He signaled that China will keep the RMB broadly stable versus a basket of currencies while allowing greater volatility against the dollar.

Zhou dismissed speculation that China plans to tighten capital controls and said there's no need to worry about a short-term decline in forex reserves. He reassured investors that there is no basis for the continued depreciation of the RMB and that China would not let market sentiment be dominated by speculative forces.

Zhou's comments helped ease the RMB's depreciation pressures and received praise from the IMF chief Christine Lagarde. "We have been delighted to see the communication efforts undertaken by policymakers, particularly Governor Zhou," Lagarde said in February, adding that it was "a good example of how communication can actually clear the uncertainties and trepidations."

At the same month, the PBOC clarified that the central parity rate formation system would be based on the closing rate of the previous trading day and movements of a basket of currencies. Such exchange rate regime reflects a balance among market supply and demand, relative stability against a basket of currencies and stable market expectations, the central bank said.

Since then the RMB has seemed to enter a more stable period, as the Fed signaled slower pace of interest rate hikes this year and market participants gradually got used to two-way fluctuations of the RMB exchange rate. Speculators have also learnt that it's not wise to battle against the PBOC.

Charles Collyns, managing director and chief economist at the IIF, said China' s central bank has been "much more successful" in currency management over the past six months, compared to the period from last August to this February.

"I think it finally convinced markets that it wanted to avoid an abrupt depreciation of the RMB once keeping market conditions broadly stable," Collyns told Xinhua, adding that "it has also shown it's possible for the RMB to fluctuate in response to short-term shifts of market conditions without destabilizing markets" .

He hoped that China's central bank would keep good communication and let the exchange rate move in line with market conditions going forward, noting that the central bank could reduce the risk of instability "by communicating more openly with markets" .

"We learned a very important lesson about the importance of communication," Dollar said, believing that Chinese authorities have "largely succeeded" in their objective of the market-oriented exchange rate reform over the past year with improved communication.

"The currency has been relatively stable. It has appreciated a little bit against the basket, but not very much, and then depreciated a little bit more against the dollar, because the dollar has been strengthening against other currencies," he said.

"The renminbi remains broadly in line with fundamentals" , the IMF said Friday in a report after concluding its annual economic health check on Chinese economy, expecting the volume of capital outflows from China to moderate this year.

"The large outflow seen in 2015:Q3-2016:Q1 will gradually moderate as the pressure from external debt repayment peters out. The secular trend of residents' acquisition of foreign assets to balance their investment portfolio is expected to continue, but not materially accelerate from current levels," the report said.

The IMF welcomed China's steps toward an effectively floating exchange rate regime and supported a cautious approach to capital account liberalization "that is carefully sequenced with the progress on exchange rate flexibility and financial sector reforms" .

The IMF last year approved the inclusion of the RMB into its Special Drawing Rights (SDR) basket as a fifth currency, along with the U.S. dollar, the euro, the Japanese yen and the British pound, marking a milestone in the RMB global march. The new SDR basket will be effective from Oct. 1, 2016.

Dollar said China has done financial reforms needed for the RMB to be officially included into the new SDR basket. He encouraged China to move ahead with structural reforms in the real economy, dealing with excess capacity, zombie firms and bad debts, which would make China's financial system more robust and underpin the RMB's reserve currency status. Enditem