Since the summer of 2015, the USD/RMB exchange rate has taken on unprecedented importance on the financial markets. The renminbi’s episodes of accelerated depreciation against the US dollar in August 2015 and January 2016 were the source of major market turbulence. They caused concerns over the Chinese economy and, by extension, the emerging markets in general, to reappear, which had a negative impact on risky assets (at least temporarily) and slowed down the Fed’s rate tightening cycle. The renminbi also took on a new status on the currency markets, with trends in the currency now a determining factor for other emerging currencies.
The successive quantitative easing (QE) programmes initiated by the Fed, the BoJ and the ECB have led to a significant depreciation in effective terms of the dollar, yen and euro which, in the post-Great Recession years, meant a substantial appreciation in the renminbi, the only important currency in the international system whose central bank had not adopted a QE policy.
In May 2016, China’s real effective exchange rate was 30% above its average value in 2008, however, in the eurozone’s and Japan’s cases, it was 14% and 11% lower respectively, and 13% higher in the United States. While the question of the renminbi being undervalued was relevant before the Great Recession, today there is no doubt that the currency is overvalued, in particular in light of the Chinese economy’s current and future challenges. The question of how the Chinese authorities should manage the yuan’s overvaluation is one of the most important for the markets over the coming years.
The renminbi reached a very high level in 2015, particularly due to the dollar’s renewed appreciation, which catapulted the need for monetary reforms to the forefront. On 11 August 2015, the PBoC announced that market forces would play a greater role in fixing the renminbi’s exchange rate. In two days, the USD/RMB exchange rate rose 2.8%. Two weeks after the renminbi was admitted into the IMF’s special drawing right currency basket (on 30 November 2015), the PBoC announced that it would no longer measure the renminbi against the US dollar alone, but rather against a basket of thirteen currencies (often referred to as the CFETS basket).
This decision was made as part of a strategy to gradually unpeg the renminbi from the dollar.
Over the last twenty years, China has taken on an increasingly important position in emerging-market trade relations, one that has now become essential. For example, China accounts for 18% of Malaysia’s exports and 20% of Brazil’s exports, compared to 8% and 3% respectively in the mid-1990s. This clearly has major repercussions for exchange rate valuations. Whereas the renminbi had little impact on the valuation of the Malaysian ringgit or the Brazilian real 20 years ago, the opposite is true today. Fluctuations in the renminbi have a major impact now.
The best way to convince ourselves of this is undoubtedly to look at the changes in the weighting of the major currencies (USD, EUR, JPY, RMB) in the effective exchange rates calculated for emerging currencies by the BIS. Charts A, B et C represent the changes in these weightings over three separate periods of time: 1993-1995, 2002-2004 and 2011-2013.
The renminbi is now the currency that has the highest weighting when calculating the effective exchange rates for South Korea, Taiwan, Chile, Australia, Peru, Malaysia, New Zealand, Thailand, Indonesia and Singapore, as well as … the eurozone, the United States and Japan. Note that for Asian countries, the weight of EUR and USD has the same order of magnitude, often below the weight of the RMB (except in the case of Philippines).
Until recently, the increase in China’s economic weighting manifested on the currency markets primarily through the impact the country’s economy had on commodity prices. The trend in the renminbi itself had relatively little impact on the other currencies because the renminbi was extremely stable and closely pegged to the US dollar. That said, recent monetary reforms changed the game in a big way.
The new Chinese currency regime led the currency markets into a new paradigm. It is clear that fluctuations in the USD/RMB exchange rate have played an increasingly significant role in emerging currency trends. One of the ways to assess the impact of the renminbi on other countries’ currencies is to estimate regressions using Frankel & Wei’s method (“Yen bloc or dollar bloc? Exchange rate policies of the East Asian Economies”, 1994).
These regressions relate exchange rate movements of currency X against a reference currency (the Swiss franc for example) to movements of four
The dominant reference currency is defined as the currency with the highest positive coefficient in the regression. We estimated “Frankel-Wei” regressions for two periods: period A from July 2014 to the end of July 2015, and period B from the beginning of August 2015 to the end of June 2016. Period A covers the first phase of the dollar’s appreciation, during which the Chinese authorities allowed the renminbi to appreciate with the dollar. Period B covers the new Chinese currency regime with the unpegging of the renminbi from the dollar and the tracking using the CFETS basket. The results are shown in the following table.
We can observe some important changes evolving the different currencies between the two periods. Our estimates suggest that the renminbi became the dominant reference currency for a higher number of emerging currencies. Specifically, for the 26 EMEs currencies assessed, the number of emerging currencies for which the renminbi is the dominant reference currency went from 10 on the period A to 14 on the period B, whereas the number of emerging currencies for which the US dollar is the dominant reference currency went from 8 on the period A to 3 on the period B. The euro is the dominant referent currency for the other currencies while the yen is not the dominant referent for any currency.
Besides, the predictive power of the “Frankel-Wei” regressions has declined for all of the currencies considered. It was very high during the period A and has declined sharply afterwards. This is an indication that EM currencies followed far less clearly the four big currencies than before. Note also that the coefficient of the renminbi increased for 17 currencies was the one that presented the largest number of increases in the co-movements with EMEs currencies in period B (17 out of 26 cases, which represents 65% of the total). The coefficient of the euro, the yen and the US dollar fell in the majority of cases.
It is particularly interesting to see that in period B the renminbi has gained ground against the US dollar as the main currency of influence for Asian economies, suggesting it has possibly supplanted the US dollar as the most important reference currency in this region. Specifically, the coefficients of the renminbi in the regressions either increased markedly or stabilized. The renminbi has also significantly increased its role in the Latam foreign exchange markets. Both results can possibly be explained by the important trade ties between China and its Asian neighbors and the strong commodity-trade link between China and Latam economies. Specifically, some works emphasizes that the weight on renminbi is plausibly a function of the commercial link but also the financial links that China has with many economies and that are as much regional as global (see, i.e., Eichengreen and Lombardi, 2015).
Specifically regarding Asia, it is important to note that our results contradict a common wisdom of the existence of a “Dollar bloc” in this region and seem to corroborate the view that the currencies in this area might try to follow a more trade effective orientation (see, i.e., Ho, Ma and McCauley, 2005). However, the USD remains the dominant reference currency for the Philippian peso and the Thailand bath and the USD coefficient remains high and significant for the Indian rupee.
Concerning Latin America, our results are particularly intriguing due to the almost inexistence of a dominance effect of the US dollar in this region. Due to geographic, historic and even political reasons, Latin America is considered as a natural zone of influence of the dollar (more on this topic, see i.e. Eichengreen and Lombardi, 2015). However, our results suggest that the US dollar has apparently lost its “backyard” to the renminbi. Note that the predictive power of these regressions fell dramatically for Latam currencies, suggesting that idiosyncratic factors played a higher role during the period: for instance, the BRL has suffered a strong influence of the Brazilian political crisis (for the BRL, the R² fell from 0.57 to 0.14). This explanation could be extended to the case of ZAR, South Africa having also suffered from major political instability.
All in all, while there are still many discussions in the literature about the potential of the RMB to potentially emerge and stand as a global reference currency ( Eichengreen and Lombardi, 2015 pointed out this as an extremely difficult thing to foresee), our results clearly suggest that the RMB has risen as a major reference currency to EMEs and its influence seems to go well beyond its neighborhood area, findings that go in the same direction of the recent literature on the topic.
The new Chinese currency regime introduced in August 2015 led the currency markets into a new paradigm. The slightest fluctuations in the renminbi have a definitely greater impact on trends in emerging market currencies than in the past. This highlights how important is the evolution of the USD/ RMB parity for emerging currencies and thus how important will be the next Chinese monetary reforms: a disorderly depreciation of the renminbi would be very negative for emerging currencies.
The renminbi took
Over the last twenty years,
Recent monetary reforms
Our results contradict a
The RMB has risen as a