In August 2015, the People's Bank of China (PBoC) lifted the U.S. dollar/yuan fixing rate by 1.9 percent. This stunned markets and caused widespread confusion. Was this an isolated event, or did it signal a move towards floating the yuan?
Currently, China's domestic, "onshore" Renminbi (CNY) does not float freely against other currencies. The CNY is pegged to the U.S. dollar with a fluctuation band of plus/minus 2 percent. The centre of the band is reset each day by the PBoC, which buys and sells currencies to maintain the CNY within the band.
As part of China’s efforts to internationalize its currency, an “offshore” Yuan (CNH) was introduced, traded by the Bank of China through Hong Kong. The CNH floats freely against other world currencies. The difference between the CNY and CNH exchange rates indicates the extent to which China is manipulating its currency.
Government Controls On Exchange Rates
It is widely believed that China maintains the CNY at too low an exchange rate to benefit Chinese exporters at the expense of exporters from other countries. But in the past year, the CNY’s Real Effective Exchange Rate (REER) has risen by 13 percent - to the detriment of Chinese exporters – and the midpoint of the CNY trading band has been persistently above the CNH rate, which suggests that China has actually maintained CNY at too high a currency rate. In a statement at the time of the August 2015 devaluation, the PBoC explained that the central bank fixing point was nearly 2 percent above the offshore exchange rate and needed to be brought back into line.1
The PBoC said that in the future, the daily fix would take account of market currency rates. If true, such an adjustment would narrow the gap between the CNY and the CNH, possibly making further sharp devaluations unnecessary. But according to Khoon Goh, a Singapore-based strategist at ANZ Banking Group quoted in Bloomberg, "the one-off devaluation of the fix and allowing more market-based determination takes us into a new currency regime".2
As the CNY and the CNH move closer together, the need for a separate offshore currency should slowly decline. The Chinese government hopes that liberalizing the CNY will enable it to be included in the IMF's SDR basket and eventually become a global reserve currency.
However, many analysts believe that liberalizing the CNY will mean further devaluation down the road, and that authorities could also tighten capital controls.
So How Can Businesses Prepare For This?
Businesses exporting to China could see terms of trade worsen if CNY falls. Conversely, businesses importing goods and services from China may benefit from a falling CNY.
Currency fluctuations are a common risk for businesses in the import and export industry. Forward Contracts can help businesses manage their foreign exchange risk.
Forward Contracts are agreements between businesses and foreign exchange providers to buy or sell foreign currency at a fixed rate of exchange at a future date. They allow businesses to lock in an exchange rate now to avoid currency fluctuations and gain flexibility when business circumstances change.
In the short term, businesses may need to protect themselves from exchange rate volatility as the CNY adjusts to a sustainable level. But in the longer term, liberalization of the currency regime should make it easier to do business in China.