While I generally don’t like to write just quick hits, preferring to provide more detail and analysis in my writing, based upon the rapid evolution of events and number of questions swirling around, I feel it more appropriate to try and answer specific important questions I see being asked. With that, let’s delve into a bunch of the questions I see floating around about RMB policy.

1. Did China free the RMB to market forces? Yes and no. China is allowing the market to influence the RMB price that the PBOC announces every morning but the PBOC still retains ultimate authority over the official trading price. The PBOC will take into account the actual trading price of the RMB from the previous end of day when setting the new official price. The gives the market influence in setting the new price but the PBOC retains ultimate authority. Think of this as China’s Solomon like attempt to allow the market influence while also limiting its influence. There are three specific issues of notes. First, this is Beijing’s way of having its cake and eating it too. It can say it is increasing market influence while maintaining ultimate control. Second, while the PBOC does appear to set the daily price based upon the previous days trading price, it is also intervening in the market to influence the near end of day price. Third, interestingly, the PBOC appears to be setting the price with a clear nod towards the offshore market which has been priced at an even larger discount than the onshore rate. This would appear to recognize the importance of the global market for RMB or Beijing’s willingness to allow the RMB to sink lower, probably both. In short, Beijing and its critics can both claim that it is brining the RMB closer to the market and maintaining tight control.
2. Did China take this action with the RMB to try and join the treasured SDR, jump start growth by increasing exports, or due to increasing pressure on the RMB? Probably all of the above in happy coincidence more than masterful design. Let me rephrase the question to make my point. Would China increase market influence on the RMB to please the IMF if the economy was strong and capital was not rapidly leaving the country? I think that would be considered very unlikely. China had no problem thumbing its nose when complaints were flooding in that the RMB was undervalued, so I would consider it unlikely that China is doing this to please the IMF with an eye towards joining the SDR. Rather, I would posit that multiple factors came together that made this move logical. As the Financial Times has pointed out via Patrick McGee, the real test will come when the currency moves in a direction that goes against Beijing’s wishes.
3. Is China starting a “currency war”? Yes and no but more no than yes. Journalists and politicians have fallen back on the tired cliche that Beijing is starting a currency war as a way to stimulate growth at the expense of other countries. There are multiple problems with this narrative though. First, the total decline so far is a little more than 4%. That isn’t enough to seriously stimulate Chinese exports Paul Krugman has pointed out. For the worlds second largest economy any increase resulting from 4% would be little more than statistical noise. Second, a significant share, though less in recent years, of Chinese exports is processing trade of imported inputs. Consequently, while export prices may decrease, import prices will increase essentially washing any advantage. For instance, a large percentage of “high tech” exports rely heavily on imported components acting effectively as an assembly center. This further reduces the impact of any devaluation. Third, most regional neighbors, and business competitors, have largely fallen in line with the RMB reducing any cost advantage China may gain from the lower RMB. Both for political and market based reasons, emerging market currencies and Chinese competitors are falling with the RMB negating any real impact China hoped to gain. What China may or may not realize is that the falling emerging market currency battle was seen over the past 12-18 months when Beijing refused to unpeg the RMB. Beijing chose to appreciate with the dollar and now is fighting a war that is already over. Short of a massive devaluation, Beijing is stuck with the consequences of its own policy decisions. Fourth, though US politicians may release catchy press releases complaining about the devalued RMB, they have gotten part of their wish, even if it isn’t the outcome they hoped for. Being pro-free market means being more worried about the methodology than the outcome. Beijing have given the market a bigger role in determining the price of the RMB, even if US politicians don’t like the outcome that produces.
4. China can devalue the RMB because it doesn’t need to worry much about foreign denominated debt. Yes and no. As a percentage of GDP and financial markets, China has relatively little foreign currency denominated debts. According to a recent estimate, China has approximately $1.3 trillion in foreign denominated debt. While that may be small in relative terms, given the nature of a credit stressed economy, the relative concentration in strategic sectors like real estate and carry trading, and the Beijing hope that foreigners would buy a lot of government bonds at friendly rates, the lower value of the RMB is going to have an oversized impact. Given that approximately 500 firms still have suspended trading in shares due primarily to debt covenants that would require additional collateral after share price falls, 3.6 trillion in in provincial debt restructuring due to loans coming due, and now $1.3 trillion in foreign debt, the Chinese economy should be considered a very credit stressed economy. Any significant problem would risk triggering a wave of collapses or defaults. I would add that given the long term inviolable stance China took to the RMB/$ peg, all evidence indicates that Chinese traders and firms are unhedged or poorly hedged. While it is not a large relative part of the economy, there are many real reasons to not overlook the risks.
5. With $3.6 trillion in reserves, China will have no problem defending the RMB and imposing its preferred value on the market. Yes and no but more no than people think. One of the most common mistakes people make looking at Chinese data is distinguishing between absolute and relative data. $3.6 trillion is a large amount of reserves in absolute terms but much smaller in relative terms. According to my calculations, reserves relative to nominal GDP for 1997-8 Asian tigers is 23% compared to China’s current 34.7%. However, if you compare reserves to M2 money supply the picture is much different. By that measure, China only has reserves equal to 17% of M2 versus 28% in 1997-8 Asian tigers. Given the large demand to move assets out of China, primarily by Chinese firms and individuals it should be noted, the $3.6 trillion in reserve assets looks much smaller against the enormity of its wealth and asset base. If Chinese investors and individuals start to feel significant concern about the RMB, the demand for foreign assets could turn into a flood rapidly if the PBOC fails to arrest the decline. $3.6 trillion is a large number but in the world second largest economy with 1.3 billion, that should be thought of as a small $3.6 trillion.
6. What is driving the downward push in the RMB? Confidence in the Chinese economy or more accurately, the lack thereof. Beijing officialdom and the PBOC can insist until they are red in the face that the economy is fine and there is no basis for the market pushing the RMB lower, but much like the official 7% GDP growth or Chinese milk powder, no one is buying it. Well heeled Chinese have been moving assets abroad for some time, a process which has sped up, and Chinese firms, especially those with international interests, have been stashing cash abroad as well. Debt and stock markets being propped up to avoid collapse coupled with deflation have never been known to be an investor paradise. These are characteristics of an economy that investors and citizens seek to take their money out of and put it elsewhere. Interestingly, Beijing has said it seeks to better control the offshore market where it exerts less control and unsurprisingly sees an even weaker RMB than the onshore rate. This cuts to the heart of Beijing and the PBOC’s complete lack of credibility as it is hard enough to manage the RMB market Beijing has the most control over much less a global market in trading centers in Hong Kong, Singapore, Taipei, London, Sydney, and New York to name a few. Beijing and the PBOC simply don’t understand the market or the enormity of the FX market if it seeks to control the offshore RMB market. The real risk is that Beijing does not understand global financial markets, as demonstrated by the inept response to the stock market fall, and will turn a declining RMB into a collapse. The PBOC reset expectations about future policy and prices which risks becoming a self fulfilling prophesy. The PBOC will have to rapidly improve its communication and market credibility if it wants to establish confidence in the Chinese economy and RMB pricing. Right now and based upon recent history, that is a risky bet.