On January 22, after the introduction of quantitative easing (QE) policy by the European central bank and a fast depreciation of the euro against the U.S. dollar, the RMB exchange rate against the dollar fell by 193 points to close at 6.23. In late January, the RMB exchange rate against the dollar even slumped to the lowest point in eight months and the reference rate of RMB against the dollar dropped by 1.93%. RMB exchange rate against the dollar fell by 0.75% in January. Now the market expects a further depreciation of RMB in the future.
Why did the European QE policy lead to the depreciation of the RMB exchange rate? Why did the depreciation touch off an uproar in China's market? And where will RMB exchange rate against the dollar go in the future?
As the writer pointed out early that after European central bank launched its QE policy, the euro will tend to depreciate because of its oversupply. The depreciation of the euro will naturally cause the dollar and other currencies to appreciate. There is no exception for the RMB. However, because the RMB has been pegged to the dollar for many years, an excessive depreciation of the dollar will also increase the pressure of RMB depreciation against the dollar. But the euro's depreciation against the dollar and RMB will not necessarily depreciate RMB against the dollar. This will depend on China's central bank's evaluation of European QE's impact on international market. Not long ago, RMB depreciated against the dollar for three consecutive days within the 2% floating band allowed by the central bank, which is assumed to be a kind of test that China's central bank used to evaluate European central bank's QE.
Basically, the current RMB exchange rate does not stop the guidance of China's central bank. China's central bank allowed a widened RMB depreciation band to measure European QE's impact on RMB exchange rate and Chinese economy. Unless the central bank allows more RMB exchange rate flexibility, the RMB will only depreciate in the “exiting flexible way.”
More importantly, the central bank changed the present RMB exchange rate two essential ways: first is to increase the flexibility of RMB exchange rate to reduce arbitrage gains by international hot money through unilateral use of RMB exchange rate; second is to accelerate RMB's internationalization and RMB status in the international market. Based on these two aspects, RMB exchange rate will constantly seek new balance points; otherwise a depreciated RMB cannot be internationalized.
In case of a fast appreciation of the dollar against the euro, RMB needs to keep the following conditions if it will also become a strong currency after the dollar: the first condition is that the funds flowing out of the euro system can equally flow to dollar assets and RMB assets; the second condition is a consistent Chinese economic growth cycle with that of the U.S.; the third condition Chinese monetary policy goes in line with the U.S. Fed monetary policy; and the fourth condition is the consistency of China and the U.S. exchange rate markets' environment. Currently, it is impossible to meet these conditions.
First, judging from Chinese and the U.S. economic cycle, after the financial crisis in 2008, the U.S. economy has begun to recover and prosper. However, after massive economic growth, China is facing increased pressure of downward economic growth, which has sent the international market flow into the U.S. and out of China (the reduction of China's funds outstanding for foreign exchange in 2014 means the outflow of funds from China). Under these circumstances, the RMB faces much greater pressure of depreciation against the dollar.
Second, assuming China and the U.S. economic cycles are consistent, fast euro depreciation and the RMB's strong appreciation against the dollar will severely weaken the international competitiveness of Chinese commodities in the European market, thus causing comprehensive deficits in China's import and export trade. The occurrence of this phenomenon will inevitably force RMB to depreciate.
Third, although the RMB exchange rate is still guided by the central bank, the changes of RMB exchange rate will depend on all kinds of balances in order to accelerate the internationalization of RMB. In case of global competitive depreciation among non-dollar currencies, China's central bank will move down RMB exchange rate balance point because overvalued RMB will not only be bad for China to get out of the current economic difficulty, but will also make international hot money flow back to China.
Fourth, the dollar is a freely convertible currency while RMB is not yet a freely convertible currency, so the two countries have different exchange rate systems. More importantly, the monetary policies of the two countries also differ greatly. The US monetary policy is gradually getting tight – shown by increasing interest rates this year – and will get much tighter. Chinese monetary policy now is in a dilemma. It will not be loosened for fear of increasing domestic financial crisis but will have to guarantee adequate market liquidity at the same time. Thus, RMB will not appreciate after the dollar gets stronger. Instead, depreciation will be its trend.
In a word, the European central bank's QE may impose a big effect on China's economy, thus increasing the depreciation pressure for RMB. The size of RMB trading band will completely depend on how China's central bank will balance the exchange rate relations among all currencies. Recently, RMB depreciates in the existing trading band, so market should not make an over-interpretation of this.
