In the first half of this year, the renminbi (RMB or yuan) exchange rate against the U.S. dollar (USD) once depreciated by 3% to a low level of 6.2676 and gradually rebounded afterwards. So far the accumulative appreciation of RMB was 2.3%, narrowing the depreciation margin of the yuan to about 1% within the year. Since the end of this June, the RMB to USD exchange rate has basically stayed around 6.15.

But, the situation both at home and abroad recently changed a lot. The US Federal Reserve announced its withdrawal from the third round of quantitative easing (QE) at the end of October. Afterward, the Japanese central bank strengthened its QE. It not only caused a fast rise of the U.S. dollar exchange rate which made its overall exchange rate rise to the level of 88, but also caused a fast depreciation of the Japanese yen and the substantial deprecation of non-dollar currencies (such as the Euro and other Asian currencies). The yuan has been pegged to the US dollar for a long time and is the only currency that appreciated when the U.S. dollar went strong this year. However, with the substantial depreciation of the Euro and Japanese yen (which depreciated by 9.3% and 12% respectively this year) as well as the great depreciation of other non-dollar currencies, the RMB will be weak.

The issue now is how the Chinese government will weigh the following issues. First is the internationalization of RMB. Since the beginning of this year, RMB internalization has been very fruitful: Britain issued RMB-denominated sovereign bonds, RMB can now be directly converted into Euros, and China signed currency swap agreements between Russia, Canada, and other nations. Because of these agreements, the amount of yuan used in global trade settlements has gradually increased. Without a strong RMB, the yuan will be unlikely to go global. This is why RMB gradually appreciated after its sudden and sharp depreciation in the first half of the year.

Second, if RMB only becomes strong when the U.S. dollar is, the weakening of non-dollar currencies like the Japanese yen will then have a severe impact on China’s export margins. According to China’s recent import and export data, lower exports can lead to a lower trade surplus and, in addition, the overall economic environment can weaken, all of which are unfavorable factors to the maintenance of a strong RMB. Even if RMB does not face a risk of big depreciation, the pressure of its depreciation is rising.

Third, with the gradual appreciation of RMB, international hot money again began to flood into the Chinese market. In order to curb another inflow of international hot money into China, which could cause the prevalence of arbitrage investment with the help of RMB appreciation, China’s central bank is likely to intervene again as it did in this February so as to let RMB depreciate to some extent to fight off the speculative investment.

Fourth, above all, whether RMB depreciate or appreciate lies in how to guarantee the China Central Bank monetary policy initiative. It can be seen that China’s monetary aggregate is not only the largest in terms of scale, but is growing faster than the other major global economies. Its main reason differs from that of the developed markets in the United States and Europe. Europe and the U.S. often expand its monetary aggregate by lowering their benchmark interest rates and purchasing bonds to expand the monetary base. However for China, buying foreign currencies was the major channel through which China enlarged the monetary base in recent years. The China Central Bank monetary base expanded through buying foreign exchange stands as China central bank’s “outstanding funds for foreign exchange.” By the end of 1999, China central bank’s outstanding funds for foreign exchange was RMB1.40 trillion and rose to RMB26.43 trillion by the end of 2013, increasing by nearly 19 times. Outstanding funds for foreign exchange account for 83.3% of China Central Bank’s total assets. It is where the asset structure of China central bank differs most from that of the other central banks.

All outstanding funds for foreign exchange become enterprise and personal deposits in banks. The fast growth of the funds outstanding for foreign exchange will also accelerate the growth of China’s domestic monetary aggregate. To control the fast growth of monetary aggregate, China’s Central Bank had to raise the bank reserve requirement, which is the main reason behind its abnormally high rate now. The adjustment of bank reserve requirement became the most important but passive monetary policy tool of China central bank during the period.

Since using outstanding funds for foreign exchange is the main way to expand a nation’s monetary base and the adjustment of bank reserve requirements mainly depends on the increase or decrease of outstanding funds for foreign exchange, thus, China central bank’s monetary policy had to be passively adjusted with these increases or decreases over the years. This is the main reason that China domestic monetary aggregate was passively large and passively grew fast. Whether outstanding funds for foreign exchange grow slowly or quickly is closely related to the changes of the RMB exchange rate.

In previous years, the fast growth of outstanding funds for foreign exchange is fundamentally due to the unilateral consistent appreciation of RMB. If the situation remains unchanged, China’s monetary policy will be unlikely to cope with economic changes proactively. Therefore, in view of the current situation, China Central Bank’s monetary policy will focus on the disposition of its high level of outstanding funds for foreign exchange and on changing the situation of unilateral appreciation of the RMB exchange rate. A moderate depreciation or some fluctuation should be a normal effect of these RMB exchange rates.

The current situation predicts that the RMB is more likely to enter a new round of depreciation or will have a smaller space for appreciation.

Yi Xianrong is a researcher at the Financial Institute of the Chinese Academy of Social Sciences. See more at: http://www.ccgp-fushun.com/opinion/yixianrong.htm

This article was first published at Chinausfocus.com To see the original version please visit http://www.chinausfocus.com/finance-economy/will-the-rmb-enter-a-new-round-of-depreciation/