Moody's: China advances exchange rate reform, a credit positive

Moody's Investors Service says that the shift in the mechanism for determining the daily fixing rate of the renminbi against the dollar is credit positive because it will increase currency flexibility and support steps to liberalize China's capital account.

On 11 August, the People's Bank of China announced that it would start basing the fixing rate of the renminbi against the dollar on the previous day's market prices.

In Moody's view, the most significant credit implication of this policy shift is that it constitutes progress along the path towards capital account liberalization.

On the other hand, the depreciation that followed the shift in the exchange regime does not have material credit implications because it will not significantly bolster export growth. In addition, China's strong external reserve position limits any negative credit impact from market volatility.

Moody's conclusions are contained in a just-released report, 'Government of China: Advance in Exchange Rate Reform is Credit Positive for the Sovereign.'

The report notes that the change in the exchange rate fixing mechanism may go some way towards addressing a concern the IMF has expressed in its ongoing assessment of whether to include the renminbi into its basket of currencies used to determine the Special Drawing Rights (SDR) rate.

Currently, four currencies--the dollar, the euro, pound sterling and the yen--are used to calculate the SDR.

The renminbi depreciated by about 3.5% against the dollar in the two days following the shift in the exchange rate regime. Moody's notes that there could be some further downward pressure on the exchange rate this year, but a sharp depreciation is unlikely.

According to Moody's, there are a number of fundamental factors that should support the exchange rate. These include a sizable current account surplus, and an estimated $3.7 trillion in official foreign exchange reserves. Moreover, the Chinese economy's net international assets are equivalent to 17% of GDP, and allow it to withstand some amount of exchange rate volatility.

According to Moody's, the magnitude of current RMB depreciation, which follows an 8.3% year-on-year fall in exports July, is not large enough to boost China's currency competitiveness against its trade competitors and partners.

Thus, the restoration of sustained, stronger export growth will likely depend on a more robust recovery in demand from the developed market economies than currency depreciation.