The Devaluation of China’s National Currency: Causes and Implications

The financial crisis in China is a kind of an exam, which gave us all a chance to assess both the level and the quality of that country’s financial market.

Economic crises invariably come as a test. The financial crisis in China is a kind of an exam, which gave us all a chance to assess both the level and the quality of that country’s financial market, and the maturity and quality of its state regulation methods. Overall, China's financial system has been doing fairly well during this test.

The People's Bank of China (PBC) decision to devalue the RMB in August 2015 can be rationalized primarily in the context of the current crises unfolding in the Chinese economy. Slower growth rates and a falling current account balance surplus have revealed structural problems in China's economy. Acting in full accordance with the recommendations of classic economics, China's financial authorities proceeded to stimulate the aggregate demand, including monetary pumping. China's central bank cut lending rates on three occasions within a year, taking it down to 4.85 percent from 6 percent. Bank reserve requirements were reduced from 20 percent to 18.5 percent.

The economy thus got an injection of liquidity, but it didn’t drastically increase the amount of investment. The securities market, more specifically the Shanghai Stock Exchange and the Shenzhen Stock Exchange, offered much more lucrative investment opportunities. It was a typical securities market bubble. When it burst, the economy came under a lot of strain. The Shanghai Stock Exchange index plummeted 33 percent in August 2015. More cash was needed to stabilize the market.

This situation was further exacerbated by the PBC pegging the RMB exchange rate to reserve currencies, primarily the US dollar. The RMB began to be used in international trade right after the 2007−2009 financial crisis had been somewhat alleviated. The starting mechanism for launching the RMB as a settlement currency in international trade agreements was based on agreements for reciprocal currency swaps that the People's Bank of China signed with foreign central banks. The central banks of foreign countries were thus able to exchange their national currencies for the RMB and sell the RMB to their domestic companies for them to purchase Chinese-made goods.

This has led to the accumulation of the RMB in the offshore accounts of China’s foreign partners. As of early 2014, the supply of offshore RMB exceeded 1.5 trillion, which is equivalent to about $250 bn. Currency regulation specifics in China resulted in two types of RMB becoming available on the market: onshore RMB that are stored and circulate in China; and offshore RMBs that are stored and circulate outside China. (Valentin Kasatonov. The Internationalization of the Yuan. Oct. 30, 2014).

On July 19, 2010, the PBC signed an agreement with the Bank of China (Hong Kong), which acted as the sole authorized clearing bank for RMB in Hong Kong, on opening and managing accounts in RMB, without restrictions, for all nonbank financial institutions. This agreement also allowed all RMB holders to transfer funds between accounts in RMB at all Hong Kong banks. Thus, an offshore RMB market was established in Hong Kong, which was called CNH - Chinese RMB delivered in Hong Kong. The domestic onshore RMB is denoted as CNY. (V.P. Andreyev. The Internationalization of the Yuan: Intermediate results and prospects. Money and credit. No. 5, 2011, p. 39).

Until today, onshore and offshore RMB had separate exchange rate quotations. In fact, there are two foreign exchange market mechanisms. Most offshore RMB are deposited in Hong Kong bank accounts. Onshore RMB are primarily exchanged for offshore RMB in Hong Kong. Regulations over the use of offshore RMB, the conversion into onshore RMB, remained in place. These operations are permitted, primarily, for payments under commercial transactions. There are four major offshore RMB markets: Hong Kong, London, Singapore and Taiwan.

The PBC created an additional experimental currency exchange mechanism in the form of the Shanghai Free Trade Zone. Foreign investors admitted to the zone use purchased RMB for trading on the Shanghai Stock Exchange (Valentin Kasatonov. The Internationalization of the Yuan., Oct. 30, 2014).

Until August 2015, the offshore RMB was directly pegged to the US dollar with a fixed exchange rate. Fluctuation was allowed within 2 percent. At a time when the PBC was using a peculiar version of quantitative easing to spur the economy, the exchange rate to the dollar remained stable. At the same time, the US dollar continued to strengthen against all other major currencies, which led to the RMB exchange rate becoming overvalued. This situation ran counter to the PBC’s efforts. The RMB exchange rate wasn’t helping to boost exports. At the same time, the high exchange rate was of no use in trying to attract investors to the securities market, since trading Chinese companies’ stocks and bonds remained off-limits to foreign investors.

The solution to this dilemma was quite straightforward: the RMB exchange rate was now determined by the market; from now on, it will be determined by quotations provided by currency dealers, depending on market close the day before. As a result, the RMB to US dollar exchange rate fell 3 percent in a matter of a few days in August.

Professor Eswar Prasad of Cornell University, former IMF country head for China, commented on the event as follows, "The People’s Bank of China has orchestrated a clever combination of a move to weaken the renminbi with a shift to a more market-determined exchange rate.” (, Aug. 11, 2015).

However, the international markets reacted to the PBC decision to lower the RMB rate in a surprisingly strong, almost panicky, manner. Most analysts concluded that China had begun an open currency war. Everyone began talking about the competitive devaluations of major currencies during the Great Depression of the 1930s. Back then, things ended terribly with the introduction of isolated exchange and customs zones. The global recession was not overcome until World War II.

Even if these predictions of doom seem like a gross exaggeration, the painful reaction to the developments on the Chinese markets is understandable. Especially since they were totally unexpected and don’t come with timely clarification.

Clearly, such a strong international reaction was due to the perceived major role of the Chinese economy in the global economic system. This economic analysis led to the conclusion that collapsing Chinese stock exchanges indexes and the RMB devaluation suggested a long-term trend whereby economic growth in China would slow. The implications of this process for the world can be negative:

1) Declining Chinese companies’ demand for imported raw materials and fuel. Analysts immediately claimed that a barrel of oil would remain at $40-$45 for a long time. Negative trends in the Chinese economy can trigger an increase in volatility across international markets;

2) Declining capital outflow from China, both private and public. As may be recalled, the government of China is the largest creditor of the US government. Of China’s gold and foreign exchange reserves totaling $3.6 trillion, approximately $1.2 trillion are invested in US Treasury bonds. China's investment in the production of raw materials in Africa employs tens of thousands of people. What will become of all of that?

3) Global financial markets are handling ever-increasing volumes of financial derivatives based on Chinese securities and currency as underlying assets. The declining role of Chinese instruments would slow this market;

4) As they implement their currency and monetary policies, many countries must take into account the "new reality" of the Chinese foreign exchange market. The protective devaluation of the Kazakh tenge has become a necessity immediately following the devaluation of the RMB. The US Federal Reserve probably included the likelihood of the Chinese currency further weakening in its assessment of the likely implications of its decision to raise interest rates in September 2015.

 Bilateral trade and economic relations between Russia and China are based on settlements in reserve currencies. At the same time, the Bank of Russia, like other central banks, has signed an agreement on national currency swaps with the People's Bank of China. The volume of mutual settlements in national currencies is on the rise, but is fairly slow. In this context, stronger market mechanisms in determining the RMB exchange rate relative to other currencies, including the Russian ruble, are a positive development.

The PBC immediately issued assurances that the devaluation will be limited, and its goal is to promote market mechanisms on China’s financial market. ( Russian Service Aug.12, 2015;) To back it up, the PBC continues its interventions on the Hong Kong foreign exchange market in order to curb offshore RMB volatility. The State Administration of Foreign Exchange (SAFE) makes recourse, if needed, to limiting the amounts of US dollars purchased by Chinese companies. The RMB exchange rate is now close to the "managed float" standards.

Gradual transformation of the RMB into a freely convertible currency is, of course, a natural trend. Significant amounts of offshore RMB accumulated in the accounts of China’s trading partners had to be used that way or another. Convertible RMB tomorrow is a much more convenient financial instrument than today’s RMB. But such a transformation also requires that the domestic financial market in China opens up to foreign investors. This includes both the securities market and the market for bank loans.

During his state visit to the United States in September 2015, Chinese President Xi Jinping, speaking to the US-China Business Council and the National Committee on US-China Relations pointed out that China will stay the course of reforms and accelerate its efforts to build an open economy. "In implementing reforms, we will strive to ensure that the RMB exchange rate is determined by market supply and demand and allow it to fluctuate either way," adding that "we will not use undervalued RMB to boost our exports." ( Sep. 27, 2015, News Front news agency, Sep. 25, 2015).

These statements were made not simply to calm investors and analysts, but they represent a clear formula for the long-term economic policy of market reforms in China.

Views expressed are of individual Members and Contributors, rather than the Club's, unless explicitly stated otherwise.