On August 11, the People’s Bank of China (PBOC) announced that in future the offer prices reported to it by market makers should be based on the closing parity rate of the market on the previous day. At the same time, the PBOC lowered the central parity rate by 1.9 percent.
The depreciation sent a shockwave around the globe. Many foreign commenters feared that the PBOC has embarked on a course of devaluation to boost China’s exports, which in turn would set off a new round of currency war.
This worry is understandable but unwarranted. As pointed out by the vice-governor of the PBOC, Yi Gang, “We do not need to devalue the RMB to promote exports.” There are many reasons to believe this is true. First, China knows well that currency wars are self-defeating. During the Asian Financial Crisis, China’s economic situation was much worse, but China resisted the temptation to devalue the RMB. Even without resorting to devaluation, China was able to come out of the crisis unscathed. Second, China is very serious about shifting the growth mode from investment-export driven to domestic consumption driven. China is still running large trade surplus, the negative impact of a further narrowing in trade surplus on the economy can and should be offset by increase in domestic demand in general and domestic consumption in particular. Third, as the largest trade nation in the world, China’s share of exports in global exports has already surpassed 12 percent. It will be very difficult indeed for China to expand its share further without worsening its terms of trade greatly. Fourth, due to China’s special position in processing trade and global value chain of production, it is difficult to assess how effective the devaluation will be in increasing China’s trade surplus. Finally, China is not only a trading nation but also a nation with huge overseas financial assets and liabilities. Chinese nonfinancial corporates’ foreign borrowing can be as high as 1 trillion USD. Any large devaluation will correspondingly increase the Chinese firms’ debt burden in RMB terms, which will lead to a large number of bankruptcies and dramatic increase in Nonperforming loans. Hence, to avoid getting involved in competitive devaluation is not only the responsibility of China as a major global power but also in the self-interest of China.
In my view, the purpose behind the action taken on 11 August by the PBOC is two- fold. First, to loosen PBOC’s grip on the RMB exchange rate so as to allow the market to play a more important role in determining the exchange rate. Second, to narrow the gap between official exchange rate and the exchange rate implied by market demand and supply so as to make the reform of the exchange rate regime smoother. Since the turn of the century, the United States and other major industrial countries have been pushing China to allow the market to determine the RMB exchange rate regime. When China made an effort towards that direction but ended up with RMB depreciation, it is legitimate for them to complain?