Guest Commentator of CFETS, Dec 14, 2015

The CFETS exchange rate index published by CFETS on its website on December 11 has caused extensive debate at home and abroad. Some people were in favor of the shift of focus in observing RMB exchange rate movements to refer to a basket of currencies, while some others continued their analysis based on the bilateral-exchange-rate perspective and saw potential rooms of RMB weakening against USD.  This shows that the focus on the bilateral RMB/USD exchange rate and the subsequent criteria of judgment and behavior was deeply entrenched. Therefore, some further discussions are necessary.

First, the managed floating exchange rate regime has been in place for a long time, which is based on market supply and demand and with reference to a basket of currencies. Since the exchange rate regime reform in 2005, most of the time RMB exchange rate fluctuated under this regime, except for few periods when management was enhanced due to China’s international responsibility as a major economy. However, with reference to a basket of currencies does not mean pegging to a basket of currencies or adjusting RMB exchange rate mechanically in line with the movements of the exchange rate index of the currencies in the basket. Market supply and demand is another important reference. The floating and flexible exchange rate is an outcome of these two factors combined with necessary management.

Secondly, observing RMB exchange rate movements should focus on a basket of currencies, but it takes time for the market to get used to this. Different economies are in different stages of business cycles and their monetary conditions and terms of trade may not be exactly the same. Sometimes the fundamental trends of different economies may even be in opposite direction. Maintaining the value of RMB stable against one single currency may lead to distortion and accumulation of imbalances, undermining the economy’s resilience to external shocks. In light of this, the PBC introduced a basket of currencies in the management of RMB exchange rate since the beginning of the exchange rate regime reform in 2005. All along, financial institutions with comprehensive coverage in their business operations have referred to a basket of currencies in FX trading, and some large commercial banks also constructed their own currency baskets to focus on the movements of a basket of currencies. However, some market participants have kept the focus on USD for simplicity. Going forward, it is plausible for all market participants to shift their focus from the bilateral RMB/USD exchange rate to referring more to a basket of currencies. This adjustment process, of course, takes some time.

Thirdly, from the short-term perspective, the effect of RMB exchange rate adjusting to a basket of currencies has unfolded. In the short run, the movement of RMB’s bilateral exchange rate against any one currency reflects, to a large extent, the different business cycles of the two economies. Exchange rate index, as a weighted average exchange rate, provides a more comprehensive measurement of the value change of a specific currency. From the beginning of this year to December 11, the CFETS RMB exchange rate index and the RMB exchange rate index based on the BIS basket appreciated 1.45% and 2.28% respectively, and the RMB exchange rate index based on the SDR basket showed a minor depreciation of 0.48%. The subtle differences among them are caused by the different weights allocated to a given currency. Generally speaking, all these indices indicate that the RMB exchange rate has been relatively stable against a basket of currencies since the beginning of this year.

Fourthly, looking at the fundamentals in the medium to long run, conditions are available for the RMB exchange rate to remain basically stable at an adaptive and equilibrium level. First of all, although the China’s growth has switched gear from a high speed to a medium-high speed, it is still relatively  high compared with other economies. Second, the growth of China’s labor productivity has been higher than other major economies, which will help buoy up export. Meanwhile, the decline in commodity prices will help slash import expenses, and keep the trade surplus at a reasonable size. January through November, the surplus of trade in goods reached 539.1 billion dollars. Third, after RMB was included in the SDR’s currency basket, we expect that overseas investors will gradually increase their holding of the RMB assets and the market is accordingly establishing a new methodology to observe RMB exchange rate. Fourth, the abundant foreign exchange reserve, the sound fiscal standing and a robust financial system jointly provide a solid foundation for the RMB exchange rate to remain basically stable at an adaptive and equilibrium level.