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Within two days of trading after China’s central bank announced on August 11 that it would improve the yuan’s central parity system， the yuan fell by more than 3 percent against the U.S. dollar. This depreciation was considered normal， especially in view of the yuan’s 15-percent trade-weighted increase since 2014. However， the depreciation did cause unexpected responses in both the Chinese and international markets.
In view of China maintaining a trade surplus for a long time， the yuan has not been overvalued. It is the balance of a country’s current account that influences the medium- and long-term exchange rate. The sharp fall in the Russian ruble last year and a fall in the currencies of Malaysia， Indonesia and Brazil this year were all due to a worsening trade balance.
In the medium and long term， if a country’s production efficiency improves faster than its trading partners， its exports will be more competitive， laying the foundations for a trade surplus and currency appreciation. It is obvious that is the case with China.
The lack of a sound basis for the depreciation of yuan begs the question as to why the market reacted so strongly to the readjustment of the yuan’s central parity rate system. Why does such a difference exist between the government’s intentions and market expectations？
Since the second half of last year， China’s economic growth has slowed down. After monetary and fiscal policies were implemented， the market naturally expected the government to readjust the exchange rate to ensure stable economic growth. When China’s central bank announced reform of the central parity system， rumors floated around the market that the government intended to depreciate the yuan by 10 percent in order to stimulate exports.
The market focuses excessively on the exchange rate between the yuan and the U.S. dollar， while paying inadequate attention to the trade-weighted exchange rate that denotes the competitiveness of a country’s products in the international market. The yuan’s exchange rate against the U.S. dollar is only part of the picture. The United States is only one of China’s trading partners， and the yuan’s exchange rate against U.S. dollar alone does not fully reflect the currency’s real exchange rate.
According to the Bank for International Settlements （BIS）， the nominal and real tradeweighted exchange rate of the yuan have both appreciated by more than 15 percent since mid-2014. It is a “passive” appreciation mainly due to the appreciation of the U.S. dollar. A 3-percent depreciation of the yuan against the U.S. dollar is therefore a normal adjustment and no cause for overreaction. Moreover， because the stock market plummeted， and the government’s stabilization measures failed to achieve the expected results， investors felt less confident in the stock and financial markets. They are changing their asset structures to hold more foreign currency assets.
The strong expectations in the market for a depreciation of the yuan run contrary to the policy intentions of the monetary authority. This round of unexpected market fluctuation can be regarded as an “accident” caused by depreciation expectations.
Although the “accident” didn’t cause fatal results， it still reveals a harsh fact： Once domestic residents and companies expect depreciation of their currency， it severely affects the stability of the financial market， macroeconomy and society. To avoid such unfavorable conditions， the government must pay attention to three factors.
First， it should guide the market to better understand China’s stage of economic development stage and exchange rate tools.
Pursuing a trade surplus used to be one of China’s policy targets. Such a goal was reasonable and necessary in the primary stage of economic development. However， this phase has ended. China has become the world’s second largest economy， and it is unlikely that high growth can be maintained merely by relying on external demand.
Since the 2008 global financial crisis， China has taken tough measures to correct external economic imbalance. The trade surplus as a percentage of the total GDP declined significantly， but the structure of China’s exports has been improved. We have no reason to believe that the government will use the exchange rate tool to support industries engaged in low valueadded exports.
Second， the government could release an exchange rate index and guide the market to pay more attention to the multilateral exchange rates.
The exchange rate between the yuan and the U.S. dollar is usually used to measure the strength of the yuan. Although the BIS releases a trade-weighted exchange rate for the yuan， it is still not widely used. Moreover， the BIS only provides monthly figures， and the market has no high-frequency and real-time multilateral exchange rate figures to use. Therefore， the Chinese monetary authority could release a high-frequency exchange rate index to clarify the overall exchange rate of the yuan for the market. The monetary authority should also encourage market participants to pay more attention to the overall exchange rate level against a basket of currencies instead of just the exchange rate against the U.S. dollar.
Third， the government must improve management of the financial market and enhance public confidence.
Usually international capital flows， especially short-term capital flows， are used to observe the influence of capital account changes on the exchange rate. However， it does not apply to China because the country is much less dependent on international financial capital than most of the other emerging economies， and securities and trans-border deposits are still under control domestically. Therefore， the most significant factor affecting the yuan’s exchange rate is not the flow of international capital but rather the behavior of Chinese residents and companies. Their confidence in the country’s macroeconomy， financial market and even social stability will be the most important factors affecting the exchange rate.
In view of China maintaining a trade surplus for a long time， the yuan has not been overvalued. It is the balance of a country’s current account that influences the medium- and long-term exchange rate. The sharp fall in the Russian ruble last year and a fall in the currencies of Malaysia， Indonesia and Brazil this year were all due to a worsening trade balance.
In the medium and long term， if a country’s production efficiency improves faster than its trading partners， its exports will be more competitive， laying the foundations for a trade surplus and currency appreciation. It is obvious that is the case with China.
The lack of a sound basis for the depreciation of yuan begs the question as to why the market reacted so strongly to the readjustment of the yuan’s central parity rate system. Why does such a difference exist between the government’s intentions and market expectations？
Since the second half of last year， China’s economic growth has slowed down. After monetary and fiscal policies were implemented， the market naturally expected the government to readjust the exchange rate to ensure stable economic growth. When China’s central bank announced reform of the central parity system， rumors floated around the market that the government intended to depreciate the yuan by 10 percent in order to stimulate exports.
The market focuses excessively on the exchange rate between the yuan and the U.S. dollar， while paying inadequate attention to the trade-weighted exchange rate that denotes the competitiveness of a country’s products in the international market. The yuan’s exchange rate against the U.S. dollar is only part of the picture. The United States is only one of China’s trading partners， and the yuan’s exchange rate against U.S. dollar alone does not fully reflect the currency’s real exchange rate.
According to the Bank for International Settlements （BIS）， the nominal and real tradeweighted exchange rate of the yuan have both appreciated by more than 15 percent since mid-2014. It is a “passive” appreciation mainly due to the appreciation of the U.S. dollar. A 3-percent depreciation of the yuan against the U.S. dollar is therefore a normal adjustment and no cause for overreaction. Moreover， because the stock market plummeted， and the government’s stabilization measures failed to achieve the expected results， investors felt less confident in the stock and financial markets. They are changing their asset structures to hold more foreign currency assets.
The strong expectations in the market for a depreciation of the yuan run contrary to the policy intentions of the monetary authority. This round of unexpected market fluctuation can be regarded as an “accident” caused by depreciation expectations.
Although the “accident” didn’t cause fatal results， it still reveals a harsh fact： Once domestic residents and companies expect depreciation of their currency， it severely affects the stability of the financial market， macroeconomy and society. To avoid such unfavorable conditions， the government must pay attention to three factors.
First， it should guide the market to better understand China’s stage of economic development stage and exchange rate tools.
Pursuing a trade surplus used to be one of China’s policy targets. Such a goal was reasonable and necessary in the primary stage of economic development. However， this phase has ended. China has become the world’s second largest economy， and it is unlikely that high growth can be maintained merely by relying on external demand.
Since the 2008 global financial crisis， China has taken tough measures to correct external economic imbalance. The trade surplus as a percentage of the total GDP declined significantly， but the structure of China’s exports has been improved. We have no reason to believe that the government will use the exchange rate tool to support industries engaged in low valueadded exports.
Second， the government could release an exchange rate index and guide the market to pay more attention to the multilateral exchange rates.
The exchange rate between the yuan and the U.S. dollar is usually used to measure the strength of the yuan. Although the BIS releases a trade-weighted exchange rate for the yuan， it is still not widely used. Moreover， the BIS only provides monthly figures， and the market has no high-frequency and real-time multilateral exchange rate figures to use. Therefore， the Chinese monetary authority could release a high-frequency exchange rate index to clarify the overall exchange rate of the yuan for the market. The monetary authority should also encourage market participants to pay more attention to the overall exchange rate level against a basket of currencies instead of just the exchange rate against the U.S. dollar.
Third， the government must improve management of the financial market and enhance public confidence.
Usually international capital flows， especially short-term capital flows， are used to observe the influence of capital account changes on the exchange rate. However， it does not apply to China because the country is much less dependent on international financial capital than most of the other emerging economies， and securities and trans-border deposits are still under control domestically. Therefore， the most significant factor affecting the yuan’s exchange rate is not the flow of international capital but rather the behavior of Chinese residents and companies. Their confidence in the country’s macroeconomy， financial market and even social stability will be the most important factors affecting the exchange rate.