Will China devalue its yuan further?

Beijing may be compelled to act again to counter the strength of the US dollar.

In the last 12 months, most emerging markets' currencies depreciated against the US dollar, helping improve their competitiveness. However, economies with a US dollar peg appreciated against other currencies. These include the export-intensive GCC countries, Hong Kong and China, which may face additional appreciation pressure after the Federal Reserve raised interest rates.
China has already acted to reverse the appreciation trend. In August, the central bank devalued the yuan following a change in the way it determines the country's foreign exchange rate, which includes taking into consideration other major currency movements rather than just the US dollar. Since then, the yuan depreciated around four per cent against the dollar, the largest five-month drop in over 20 years. Ten days ago, the central bank unveiled a new currency index: the China foreign exchange trade system (CFETS) RMB index. The index will be based on a basket of 13 currencies, with the dollar given a weight of 26.4 per cent, the yen 21.4 per cent and the euro 14.7 per cent. The CFETS RMB index will be used as an additional reference point for the central bank to determine the value of the yuan and to manage market expectations.
The release of the CFETS RMB index is a signal to the market that the central bank still considers the yuan as overvalued. In the last 12 months, the index appreciated 2.9 per cent, compared with a depreciation of 4.4 per cent for the yuan against the dollar. The index was also introduced one week before the Fed decided to raise interest rates, a move that is expected to appreciate the dollar further - and hence the Chinese yuan against its trade partners' currencies. China's move can be read as a central bank signal to the market that it plans to devalue its currency further.
China needs the stimulus boost from a currency devaluation. Exports have been contracting in nine out of the first 11 months of this year, forcing some companies to cut prices and subsequently lower wages in order to become more competitive. Moreover, in order to maintain the soft peg, the central bank has been using foreign exchange reserves to buy yuan from banks, draining liquidity from the financial system and leading to a 10 per cent decline in foreign reserves compared to last year.
A more flexible exchange rate is also in line with China's long-term objective to liberalise its currency and remove capital controls.
Having already joined the International Monetary Fund's Special Drawing Rights basket, China's willingness to reduce its currency link to the dollar is a step forward in the yuan's internationalisation process. Monetary policy would also become less dependent on the Fed.
By letting the yuan devalue, the central bank would have to intervene less in the foreign exchange market allowing for the more complete transmission of Chinese monetary loosening. Given the policy divergence between China and the US, the effect on the economy would be evident.
The announcement of the CFETS index is an implicit warning to markets that the central bank is planning to devalue the yuan as China needs to strengthen its large export sector without causing market stress.
By not having to intervene in forex, monetary policy easing could have a greater effect on the economy and China's goal to internationalise the yuan will remain on track. However, the country still has a long way to go before it can free-float its currency as destabilising capital outflows as a result of removed capital controls remain a significant risk. For now, China is focusing on stimulating the economy before it resumes its gradual implementation of reforms.
The writer is an economist at Asiya Investments Company. Views expressed are his own and do not reflect the newspaper's policy.