China doesn’t fool around. President Xi Jinping’s government reportedly spent more than $140 billion (US) to end this summer’s stock market rout. So when data on the weekend showed the value of the country's exports plunged in July, many observers anticipated a response. On August 11, Beijing delivered — and then some.
The People’s Bank of China (PBOC) stunned traders by slashing the rate at which it sets the value of the yuan, devaluing the currency by almost 2 percent. At the same time, the central bank pledged to strengthen the market's role in setting the yuan's price, in part by adopting a more transparent mechanism for determining the currency's daily peg to the US dollar. Officials insisted the sharp correction in the exchange rate would be a one-time thing. “The reform of [yuan] exchange rate formation mechanism will continue to be pushed forward with a market orientation,” a PBOC spokesman said. “Market will play a bigger role in exchange rate determination to facilitate the balancing of international payments.”
Beijing will struggle to convince its trading partners of that. Raghuram Rajan, the governor of the Reserve Bank of India, has been telling everyone who will listen that the world’s major economies are locked in a perilous game of currency destruction. The PBOC’s Zhou Xiaochuan has just strengthened Rajan’s claim. I have argued against the notion that the world is engaged in a currency war. I’m not yet ready to concede, but the facts are turning against me.
The PBOC insisted a big adjustment in yuan’s value was required to match weaker fundamentals. China’s central bank had kept the currency’s value fairly stable since the spring, even as the economy slowed. Adam Cole, an economist at RBC Capital Markets, agreed that the yuan probably was overvalued. But if China wanted to keep the faith of its trade partners, it would have let market participants weaken the currency. “Choosing to go this route brings into question China’s commitment to free-market reforms,” Cole said.
All of this raises questions about Beijing’s desire to turn the yuan into an international reserve currency. A report by staff at the International Monetary Fund last week said the Chinese currency probably wasn't yet worthy of inclusion in the basket of currencies that set the value of the special drawing right (SDR), the IMF’s in-house unit of exchange. Ultimately, market participants will decide whether the yuan deserves the same status as the US dollar, the yen and the euro. The SDR has almost no role in markets. But placement in the SDR basket would have significant symbolic value. The IMF’s stamp of approval likely would inspire confidence that the yuan’s value would be set by currency traders, rather than Beijing.
Xi’s government has been lobbying for the yuan’s inclusion in the SDR basket for years. There now is reason to think China could live with a delay. The collapse of the stock market was a blow to the government’s free-market reformers, and some of the measures taken to arrest the decline remarkably heavy-handed. The decision to actively weaken the yuan is another example that Beijing remains skeptical about the ability of market forces to deliver the economy from its current rough patch.
The IMF is set to decide on whether the yuan is ready for the SDR basket toward the end of the year. One option is to put off a final decision until 2016. That timeline could suit Beijing just fine. It would allow officials to resolve their differences over policy. The elevation of the yuan as a “reserve currency” also would make for a nice “deliverable” at next year’s Group of 20 summit, which China will host.