Many headlines have appeared in the last week about China’s decision to reduce the value of their currency, the Renminbi, by 6% over a period of three days. The People’s Bank of China directly intervened in the market for the Chinese currency. While this may seem like heavy-handed state control of what should be a free market, it is important to put this move into historical context.
Since 2005, China has increasingly let the currency be driven by free market forces. Trading of the currency has moved beyond China’s borders: The Renminbi now trades in Toronto, among other international cities. The currency has also appreciated significantly against the US dollar in the last ten years. In 2005, it took 8.28 Yuan1 to buy one US dollar. Today, despite the recent devaluation, it only takes 6.39 Yuan2. This 23% appreciation clearly demonstrates that the People’s Bank of China is allowing the currency to rise in response to the strength of their economy.
These currency changes are part of a larger liberalization of the Chinese economy. The Chinese stock market now allows foreigners to purchase A shares, which had previously been restricted to Chinese residents and institutions. In a move reminiscent of the US push to create the International Monetary Fund at the Bretton Woods conference in 1944, China has established the Asian Infrastructure and Investment Bank (AIIB). Since China holds $3.9 trillion3 in gold and foreign currency reserves, more than three times that of Japan (the next largest) and almost ten times as much as the US, they are certainly in a position to lend through the new AIIB.
As a country on the path to economic liberalization and internationalization of their currency, China has taken many steps towards those objectives. Due to their massive reserves of gold and foreign currency, they are in a strong position to smooth out the bumps along the way. This is precisely what we saw last week when the currency was deliberately devalued by 6%. Contrary to the fear and hype that the news media have created over this event, it is important to remember that short term events should never de-rail a solid, long term investment plan.
1Renminbi refers to the name of the currency, while Yuan is one unit of the Renminbi. This is similar to the UK currency name (Sterling) and unit (Pound).
2Bloomberg, August 19, 2015.
3The World Bank, World Databank, December 31, 2014.