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17 Aug 15 07:22

Last week saw the biggest official intervention in China's exchange rate since 2005. The Chinese renminbi (CNY) fell 2.9% vs. the US dollar over three days following the announcement by the People's Bank of China (PBoC) that it was shifting to "a new regime".

We believe this is a positive move, which represents a welcome step in terms of currency liberalisation.

It has introduced market forces to address the International Monetary Fund's (IMF) concern over the CNY not being "freely usable", thereby increasing the likelihood that the CNY will be included in the IMF's Special Drawing Rights (SDR) basket at the review in October/November this year. This would boost China's effort to further internationalise the CNY, joining the US dollar, euro, yen and British pound. Furthermore, the "basis" between the onshore CNY and offshore CNH has also converged, which was quite likely another reason behind the PBoC's action. 

China's new approach to currency management is now fairly similar to that of Singapore. Two things will be monitored closely from here on out: the band and slope of the trade weighted CNY index that the PBoC will adopt. The former would shed more light on the Chinese government's appetite for CNY volatility, while the latter
determines the depreciation or appreciation path of the trade weighted CNY index.

The impact on China and the rest of the world

The new currency regime is likely to lead to further capital outflows in the near term. This, in turn, poses downside risks to financial system stability and growth. We expect more CNY weakness, as trade-weighted CNY remains close to historic highs. Market volatility is likely to remain elevated, and posing downside risks to Chinese equities.

Globally, a further depreciation of the CNY will have a disinflationary impact on most developed markets, though it is unlikely to derail the Federal Reserve from hiking rates at their September or December meetings later this year. 

When all is said and done, we believe the latest move is another positive step towards accelerating the liberalisation of China's financial markets.

Do you think this is the right step, at the right time?

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