Jan Dehn, head of Research at Ashmore, discusses the Chinese government’s decision to bring the fix in line with the currency to then allow markets to determine the FX rate going forward.
China one step closer to SDR inclusion
Closing the gap between the fixing and market based valuations of the RMB is one of the key requirements for SDR inclusion. This action therefore takes China one step closer to SDR inclusion – set formally to happen this year with practical implementation starting around the time of the G20 summit to be held in China in November 2016 (where Obama will give his nod of approval as a final gesture before leaving office). SDR inclusion in turn is part of a much broader set of reforms.
Remember why China is implementing reforms, including liberalising its currency regime. The entire purpose of the reforms is to prepare the economy for RMB appreciation, i.e. a rise in the Yuan once QE across the Western world creates inflation and currency weakness in the QE countries. Inflation is likely to begin in late 2016 in the US as the drags on consumers’ willingness to respond to plentiful and cheap liquidity from household deleveraging, negative housing equity and unemployment ease.
China’s preparation and the USD issue
In the past few years, China has been hurt by its de facto peg with the USD. The USD is up nearly 40% against its trading partners and other major currencies since 2011. The USD rally has been fuelled by QE money and a perception originating as far back as 2011 (and yet to be realised) that the US is just about to have exit velocity and the Fed is just about to raise rates.
Of course, the strong USD is now also a major problem in the US. The USD is now the single largest policy issue in the US and, at the margin, the most important determinant of whether the Fed hikes.
But China is not yet ready for the massive appreciation that has come with being de facto pegged to the USD. China still has a lot of work to do in order to get ready for RMB appreciation (and consumption led growth), including implementing interest rate liberalisation, index inclusion, currency float, SDR inclusion, capital account liberalisation, development of the local government bond market, development of mutual funds, bank reforms, etc. Many of these reforms are still in the early stages.