Matthews Asia Perspective: China Currency Devaluation Update by Matthews Asia What are the factors that prompted Chinese authorities to recently devalue the renminbi? Matthews Asia Portfolio Manager Teresa Kong, CFA, examines the lead up and implications of this development. Q: What happened this week with China’s currency? A: Since 2005, China’s currency, the renminbi, has had a de facto soft peg to the U.S. dollar (USD). While its central bank, the People’s Bank of China, never explicitly stated how it determines the official daily exchange rate, also known as “fixing,” it was clear that it was largely based on the USD. The intra-day band around which the RMB was allowed to float against this fixing had widened from +/- 0.5% to +/- 2% in March of this year. On August 11, the central bank announced that the fixing, going forward, would be based on the close on the prior day. With one stroke of the pen, the driver of the renminbi fundamentally changed. Its compass changed from that of the U.S. dollar to a more market-driven equilibrium rate. Q: How does Matthews Asia interpret this change in currency regime? A: We view this RMB change, from a soft USD peg to a managed float, as first and foremost a big step forward in the government’s stated objective to liberalize its capital account. This is a logical next step in line with China’s reform agenda, its desire to be included as part of the International Monetary Fund’s basket currencies of Special Drawing Rights (SDR), and its more gradual growth path and easy monetary stance. Q: Why now? A: We think that the timing is a reflection of several factors, including the potential lifting of interest rates by the U.S. Federal Reserve, its candidacy to be part of IMF’s SDR, and a slowing economy—all of which converged to make this change take place earlier, rather than later. First, monetary policy between the United States and China has clearly diverged since the end of 2013 as it became increasingly clear that the U.S. recovery was on track, while China’s growth was slowing. As interest rates in the U.S. drifted higher and China lowered rates, the once attractive 4% pickup in yield collapsed to less than 2%. The economics of the long RMB–short USD carry trade* was no longer attractive. The same economics that squeezed the juice out of the carry trade had real effects on corporates and consumers as well. Given the choice, Chinese corporates increasingly held USD-denominated assets over RMB-denominated assets. In order to manage the USD, in the first half of 2015, China’s central bank engineered the highest sale of its reserves in the last two... More