Back to Square One in China's Exchange Rate Reform

In early 2016, the People’s Bank of China (PBOC) introduced a new rule for setting the renminbi central parity rate against the US dollar. Instead of the previous rule introduced in August 2015 where the central parity rate was set with reference to the previous day’s closing price, the rate would now be determined by the arithmetic average of two variables: the previous day’s closing price and the "theoretical renminbi exchange rate against the US dollar that will keep the index of a currency basket unchanged over the past 24 hours."

So what is this theoretical renminbi exchange rate? The China Foreign Exchange Trade System (CFETS) index can be decomposed roughly into three components: the renminbi (RMB) exchange rate against the US dollar, the US dollar index and an index of other currencies. In a chosen base date, the configuration of the CFETS index guarantees that the index is equal to 100. Hence, on any trading day with all other variables unchanged, a change in the dollar index should mean the CFETS index will deviate from 100.

In order to keep the CFETS index at 100, the PBOC has to change the bilateral exchange rate of the RMB against the US dollar through intervening in the foreign exchange market. The exchange rate that achieves this is called the "theoretical RMB exchange rate." It is worth noting that here the base date is not a certain date in the distant past: it refers to the previous day. Hence, the theoretical RMB exchange rate for a given time period is the exchange rate that keeps the CFETS index unchanged over the previous 24 hours.

According to the central parity rate setting-rule, unless the previous day’s closing price is equal to the theoretical RMB exchange rate, one cannot find a RMB exchange rate that will keep the CFETS index unchanged. For instance, if the theoretical RMB exchange rate is 6.15 and the previous day’s closing price is 6.2, then today’s central parity rate should be 6.175 — which is larger than 6.15. Hence, the CFETS index cannot be 100. So the CFETS index is not a fixed target, but is rather constantly moving.

The popular assumption that the fall in the RMB exchange rate since August 2016 is purely a result of the rise in the US dollar index is flawed. The truth is that the rise in the dollar index gave the PBOC a chance to devalue the RMB when it was already under pressure to do so while creating the impression that the RMB was pegged to the CFETS and hence its fall was the result of the rise in the dollar index. This strategy soothed the market’s nerves while allowing the PBOC to refrain from exhausting more foreign exchange reserves.

If a zero weight were given to the previous day’s closing price, the regime becomes a "pegged to a basket of currencies" regime. And if zero weight were given to the theoretical RMB exchange rate, China would return to the formula proposed in August 2015, which is essentially a floating regime. But because an equal weight is given to the closing price and the theoretical exchange rate, China can get neither the benefits of a floating regime nor those of the currency basket-pegged regime. So what objectives did the PBOC wish to achieve by introducing such a central parity rate-setting rule?

According to the PBOC, due to the uncertainty of movement in the dollar index, the introduction of a basket of currencies into price setting means that two-way fluctuations of the RMB to US dollar exchange rate are possible, which is very helpful for breaking the market’s one-way expectations as well as reducing one-way bets on the RMB. This assertion seems valid. But the sustainability of the two-way fluctuation is entirely conditional on the affordability of China’s foreign exchange reserves.

One might ask: if the dollar index is falling, where will this central parity rate-setting rule lead? Provided that the dollar index is falling and hence the "theoretical RMB exchange rate" is rising, the foreign exchange market is in equilibrium and the closing price is constant. If the central parity rate-setting rule were implemented, due to the rise in the central parity rate, the PBOC would have to sell the US dollar and buy the RMB to push up the closing price such that the spot rate stays within a small band of the central parity rate.

This result is perverse. When the RMB exchange rate is in equilibrium (or under depreciation pressure), the monetary authorities will have to force it to appreciate artificially by pouring foreign exchange reserves into the market.

Perhaps the PBOC has already foreseen this possibility. To avoid this perverse result, the PBOC recently introduced a "countercyclical factor" into the central parity rate-setting rule to correct for "big market swings" and "irrational herd behavior." Now China has three components that jointly determine the central parity rate of the RMB against the US dollar: the previous day’s closing price, the ‘theoretical RMB exchange rate and the new "countercyclical factor."

But so far no one outside the PBOC knows how the "countercyclical factor" is quantified, how it stands with the other two variables or the weights given to each component. Hence, it is no longer possible for the market to check whether the central parity rate-setting rule is followed ex post. In other words, the introduction of the countercyclical factor annuls the central parity rate-setting rule.

China’s exchange rate reform has been dragging on for far too long. Instead of showing steady progress toward a more flexible exchange rate, the PBOC is back to square one. China has already paid very high costs for its hesitation in adopting a floating exchange rate regime. It is already overdue for the Chinese government to make up its mind on completing reform of the exchange rate regime. A further delay, let alone backtracking, is not only costly but also unnecessary.

This article originally appeared in the Lowy Interpreter. The News Lens has been authorized to republish this article.

TNL Editor: Edward White