Avoid joining the currency war! Why China benefits little from renminbi devaluation.

Author:Lo, Chi

China's renminbi has entered a "new normal" environment characterized by two-way trading and higher volatility since 2014. Market players have responded by increasing onshore foreign exchange hedging activity, which contributed to last year's drop in the RMB against the U.S. dollar. Will the RMB's weakness continue and fall sharply in 2015, as some analysts forecast? What is the People's Bank of China's exchange rate policy stance? Will it shift to target the RMB's trade-weighted exchange rate, or will it continue to target the RMB-U.S. dollar cross rate, and why?

Answers to these questions will help us understand the behavior of the RMB in its new paradigm, with implications for other central banks' currency policies. In particular, will the RMB be the next currency to join the currency war? In this regard, a policy shift toward targeting a stable trade-weighted exchange rate would prompt the People's Bank of China to devalue the RMB against the U.S. dollar. But my research shows that it would likely continue to ignore the trade-weighted exchange rate and target a strong RMB-dollar cross rate for good reasons.


The People's Bank of China intervened heavily to push down the RMB-dollar exchange rate between February and April in 2014 to stamp out a one-way bet on RMB appreciation, which had gone on for many years. Since then it has intervened less even when the RMB rebounded, allowing the currency to enter a "new normal" paradigm in which two-way trading and foreign exchange volatility have finally become a reality. In fact, the People's Bank of China has been loosening its grip on the RMB since 2006, albeit very slowly, amid its appreciation trend, suggesting a gradual policy shift towards a freer RMB regime unnoticed by most players.

The RMB weakness in late 2014 that contributed to its 2.5 percent decline against the U.S. dollar for the year was due to temporary factors, which should not affect the RMB's medium-term appreciation trend. First, Chinese oil importers increased their purchases, and

hence, their demand for U.S. dollars to pay for the imports, as the decline in oil prices picked up steam in the fourth quarter of last year. Monthly crude oil imports totaled more than U.S. $16 billion in the quarter, which was 90 percent of the U.S. $18 billion daily onshore RMB-dollar spot trading volume.

More crucially, onshore foreign exchange hedging activity rose sharply in late 2014, owing to RMB depreciation...

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