A Basket Case? The Future of the Renminbi Exchange Rate Regime: Part 1
The Chinese want the renminbi to become a major international currency. But the path to that goal is complicated by the problem of how to move from the dollar link to a more market-orientated system. Taking the bold step of switching the intervention band from the dollar to a basket of currencies at the same time as widening the band would put the renminbi firmly on the road to a more flexible exchange rate regime. This would benefit China and the international financial system. This post analyzes the immediate actions required. A subsequent one looks at the Chinese actions over the last year that have created this opportunity.
Over the last six months, and especially in the last week, the Chinese authorities have put in place the building blocks to turn the renminbi into a major international currency. But the path to that goal is complicated by the problem of how to move from the dollar peg to a more market-orientated system. Last August the authorities made an important step in making the renminbi more market determined by making the morning currency fix—the rate against which intervention bands are calculated—dependent on market prices on the previous day. This sent a clear signal that the authorities were interested in moving to a more market-based exchange rate system, in line with the general view both within China and in the rest of the world that the Chinese currency system should gradually become more flexible and market determined.
The new system, however, created significant capital outflows as investors anticipated the renminbi would depreciate against the dollar. In response to this downward pressure on the exchange rate, the authorities started to intervene to maintain the rate against the dollar. Hence, despite the initial intention to move to a more market-orientated system, the final result appeared to be a more cumbersome version of the old fixed rate system involving a morning fix based on the market rate of the previous day, itself determined by intervention in the onshore market that was now less liquid and a wider onshore-offshore differential. The dollar link was becoming a source of exchange rate strain rather than its traditional role as a stable monetary regime that increased financial stability.
A solution to this conundrum was provided December 11 when the Bank of China started publishing the rate against a new basket of currencies. More precisely, the China Foreign Exchange Trade System (CFETS), a subinstitution of the People's Bank of China whose main function is organizing the interbank exchange rate market, published a new renminbi exchange rate index on its website. The new index was created with the intention of emphasizing shifts in the Chinese currency versus a weighted average of currencies rather than the dollar alone. It contains 13 currencies, with weights reflecting the importance of each currency in China’s trade.
To move toward a more market-orientated currency requires some bolder moves comprising two main components. The first involves announcing that intervention bands will be calculated from now on against a basket of currencies whose weights are known. This is needed to convince traders that the band has truly moved from the dollar to a currency basket. The second is to significantly increase the bands for intervention within the day, say from the current 2 percent to 4 percent, to make clear that the peg is in the process of being loosened.
Switching the band from the dollar to a basket and widening the intervention bands are closely linked. Part of the reason that the August switch to a more market-orientated morning fix led to so much speculation, as seen in the onshore versus offshore dollar exchange rates, is that the renminbi is linked to the dollar. The resulting capital flows reflected not simply the current competitiveness of the Chinese economy but also the likely future trend in competitiveness given that many traders expected (and continue to expect) dollar appreciation against other currencies based on better US fundamentals. The implied future loss in Chinese competiveness was seen as difficult for the authorities, particularly at a time when the Chinese economy was already slowing. The dollar link was thus helping to create expectations about future Chinese policy moves and hence helping to add to capital flows out of the Chinese currency. The dollar link was becoming a source of exchange rate strain.
Formally linking intervention bands to a trade-weighted basket and dropping the intervention limits against the dollar would thus tend to lower perceptions of “one-way bets” against the renminbi. This in turn would allow wider trading bands since traders would have more diverse views about the appropriate rate for the Chinese currency against this basket. It would also likely help to unify the onshore and offshore rates as well as make it easier to further relax current Chinese capital controls. At present, the main reason for the difference between the onshore and offshore rates are perceptions about the likely future path of the dollar rate. By switching to a band against a more neutral basket of currencies, the authorities would reduce speculative pressure including in the offshore market.
Making the bold move of linking to the new basket published by the CFETS with a wider intervention band provides the potential for a smooth switch from the current system to one where one-way bets are less obvious, incentives to overborrow in dollars are curtailed, and renminbi markets are encouraged. It would put the renminbi and international monetary system on the right track moving forward.
Author's note: The views expressed here do not necessarily represent the views of any organizations with which I am affiliated.