As a result, instead of creating two-way fluctuations in the RMB exchange rate, expectations of RMB depreciation started to creep into the market. Capital outflows driven by expectations of RMB depreciation started to rise.

In the second quarter of 2014, China’s capital account went into deficit. Then in the first quarter of 2015, China registered its first international balance of payments deficit in decades.

Since the second quarter of 2014, the RMB exchange rate vis-à-vis the US dollar was more or less stable and so were expectations. The market believed that with huge foreign exchange reserves at its disposal, the PBoC could fix the RMB exchange rate at whatever level it wanted regardless of China’s international balance of payments status.

But the PBoC’s lowering of the RMB central parity rate by 1.9 per cent on 11 August increased expectations of RMB depreciation dramatically. The PBoC quelled the panic swiftly — abandoning the reform plan and intervening forcefully to stop any further fall in the RMB exchange rate — but since then expectations of RMB depreciation have become firmly entrenched. The only question is when the next depreciation will happen and by how much.

Expectations of depreciation became a major driver for capital outflows and in turn a major factor contributing to RMB depreciation. To prevent the formation of a devaluation expectations–devaluation spiral, the PBoC started to intervene vigorously in the foreign exchange market in an unpredictable manner — making it harder for speculators to judge when to short the currency. As a result, China’s exchange rate regime morphed into a crawling peg.

While a crawling peg can eliminate expectations of an immediate depreciation, and reduce resulting capital outflows, it cannot eliminate expectations of depreciation in the more distant future, let alone reduce capital outflows unrelated to depreciation expectations. Rather, with lingering depreciation expectations, a crawling peg actually incentivises some types of capital outflows, such as yuan carry trade unwinding, household dollarisation and capital flight.

As a result of the worsening of economic fundamentals and the failure of the crawling peg to stem capital outflows, the PBoC has to spend a huge amount of foreign exchange — in the face of persistent balance of payment deficits — in order to prop up the RMB exchange rate. To keep RMB depreciation vis-à-vis the US dollar within 5 per cent, the PBoC has spent more than US$500 billion in foreign exchange reserves in 2015 alone.

The question is, if China’s economic fundamentals fail to improve significantly and expectations of depreciation remain, for how long can the PBoC defend the RMB? Since November the PBoC has allowed the RMB to devalue in a very gradual fashion to mitigate the fall in foreign exchange reserves. But as soon as the accumulated depreciation reaches a certain point or the speed of depreciation accelerates, market participants might immediately start dumping the RMB again. This is what happened at the beginning of 2016.

There are three options for solving this dilemma: stop all intervention and let the RMB float, peg it to a basket of currencies, or peg it to the US dollar tightly like China did during the Asian financial crisis. So far, there is no clear indication what the PBoC’s strategy is.

Perhaps the best option is to allow the market to decide. The fall in the RMB would probably not be too great, or would be temporary, because China is still running large current account and long-term capital account surpluses. Plus, China has not fully opened its capital account yet. China’s corporate foreign debt is not that large, the currency mismatch is small and inflation is just above 1 per cent, so even if there is a double-digit fall in the RMB exchange rate, it is difficult to see why this would lead to a financial crisis.

The main concern is that if China’s foreign exchange reserves deplete as fast as they did in 2015 they will soon be exhausted. Even if China can stabilise the RMB with its foreign exchange reserves, this would be too costly.

That said, if China wanted to play it safe, as a transitionary step, it could peg the RMB to a basket of currencies with an adjustable central parity and a wide band of 7.5 per cent or 15 per cent.

Another option is to peg the RMB to a basket of currencies with a very wide unannounced band. This strategy aims to divide investors. Hopefully, before the RMB falls to the unannounced floor of the band, many will think it has fallen enough and start to buy RMB again. If this happens, the RMB could stabilise without using any more foreign exchange reserves.

Speaking at the World Economic Forum on 25 January the Governor of the Bank of Japan, Haruhiko Kuroda, rightly suggested that capital controls would allow Beijing to maintain its foreign exchange reserves. As a necessary condition and last resort, for any new exchange rate regime to work, the PBoC has to tighten capital controls. Hopefully, the PBoC can do this without changing any existing rules. But, at this late stage, this may prove difficult.

This will be another difficult year for China. But with the right policy mix, China should be able to stabilise its economy and the RMB exchange rate will find the right level.

Yu Yongding is Academician of the Chinese Academy of Social Sciences and Member of the National Development and Reform Commission’s Expert Committee on National Planning. He served as Director of Institute of World Economics and Politics from 1998 to 2012, and on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006.