Here are two things that China’s government wants very badly: first, for its economy to remain on an even keel, keeping growth and employment high. Second, for its currency, the renminbi, to become a pre-eminent global currency that helps promote the country’s diplomatic goals and solidify the country’s centrality to the global economy.
Frequently those goals are in conflict. But Tuesday, it found a way to advance both at once.
That is how to make sense of some blockbuster news out of Beijing that the country will adjust how it manages the renminbi to make the currency’s value respond more closely to market forces.
The immediate result was a de facto devaluation, with the Chinese currency falling 1.8 per cent versus the dollar and 2.2 per cent versus the euro Tuesday. Those are big moves for the renminbi, considering that the government had a policy of maintaining a strict trading band – enforced with both legal restrictions on the transfer of capital and the government’s trillions in reserves. Usually, the renminbi will move only a few hundredths of a per cent against the dollar in a given day; the largest move this year was 0.16 per cent.
But a roughly 2 per cent shift in the value of a currency, even a major one, is not that big a deal, and certainly not the kind of thing that would earn blaring headlines about a devaluation. The dollar has risen 22 per cent against the euro in the last year; the Japanese yen plummeted 24 per cent against the dollar in late 2012 and early 2013.
What makes the Chinese move fascinating is what it says about China’s approach to its currency and economy, and about the country’s role in the global financial system in the future.
The Chinese economy is unquestionably in a rough patch, and maybe something worse. Growth is downshifting from the double-digit rate of a few years ago, and the country’s investment-and-exports-driven growth model is looking exhausted after driving a generation of prosperity. A stock market crash in the last few months has not helped.
But a hidden cost of the Chinese government’s strategy of keeping the renminbi within a narrow trading band versus the dollar has been that China has been unable to use one of the crucial tools most countries use when they are in an economic slowdown.
The renminbi on Monday was at about the same exchange rate versus the dollar that it was in mid-December. But in that span, the dollar index was up 8.7 per cent, meaning the dollar – and by extension the renminbi – was up that much against the currencies of other advanced nations like the euro, the Japanese yen and the British pound.
Linking the value of its currency to the dollar has had benefits, but in the last year has come at a big cost: It has resulted in the renminbi’s rise against competitors and trading partners at a time the economic fundamentals of China would argue for it to fall.
Meanwhile, China is looking to assert more of a leadership role in the global economy, and an important piece of that is establishing the renminbi as a reserve currency. The dollar and the euro have a reach and usefulness far beyond the borders of the countries that issue them, and China would like the yuan to have a similar sway in global trade and finance, especially within Asia.
But you cannot really be a global reserve currency when you maintain all the restrictions that China insists upon in the interest of keeping control of its domestic economy. The dollar would not play its central role in global finance if the US government made it illegal to exchange it for other currencies in many circumstances or used legal prohibitions and aggressive interventions to keep its value from fluctuating in response to market forces.
In other words, China has wanted some of the diplomatic benefits of the renminbi’s becoming a more important currency abroad, without paying the price at home.
Just last week, the International Monetary Fund said that the renminbi was not quite ready for prime time for inclusion in the basket of currencies it uses for “special drawing rights,” a reserve asset that currently is a mix of dollars, euros, yen and pounds. Christine Lagarde, the IMF’s managing director, said China needed to make its currency more “freely usable.” And the policy change on Tuesday, by moving closer to a world in which markets determine its price, is a step in that direction.
That does not mean it was without cost. The cheaper renminbi will mean higher inflation and will create an even greater burden for Chinese companies that owe money in dollars, potentially setting off a new round of failures.
Perhaps more important in the long run, as China liberalizes its currency, it gives up a crucial tool that the government has used to manage the economy for years and protect itself from being buffeted by global economic forces. China’s leadership has been reluctant to give up that power, and that is why Tuesday’s announcement came as such a shock across global markets.
But it is not often that a policy choice helps achieve two big national goals at once. And when faced with that, it appears China’s leaders were willing to give up a little bit of power for, they hope, better economic results at home and a bigger role in the global financial system abroad.