China’s RMB balancing act

Author: Editors, East Asia Forum

China is aiming to transition to a floating exchange rate — freely determined by the market — and to free capital flows in and out of China with an open capital account over the next decade. If this objective can be achieved, it will be unequivocally good for China and the global economy.

Since China is already the second largest economy globally and the world’s largest trader, a floating exchange rate will better reflect the true value of relative prices between China and the rest of the world. It will also act as a shock-absorber to major changes that are bound to occur between China and the rest of the world. An open Chinese capital account will do for global finance what China’s WTO accession did for global trade — better integrate China into the global economy.

How that transition is managed will be one of the most important factors influencing the performance of the global economy in coming years.

Economies (or their central banks) can only sustain two of the following three policies: a fixed exchange rate, free capital flows and an independent monetary policy. That’s the widely understood impossible trinity in international economics.

In 2005 the RMB moved from a hard peg to the US dollar to a managed peg with increasing flexibility. Concurrently the capital account has become more porous. As such a large global trader involved in so many complex cross border exchanges it is quite easy to move money in and out of China legally, albeit with significant limits and restrictions, as well as illegally.

The transition to a floating exchange rate will take time, but it is also a transition that is costly to drag out. Moving quickly to an open capital account and a floating exchange rate without having developed and liberalised domestic financial markets could spell financial crisis and disaster. In the transition Chinese markets will be at the mercy of hedge funds, speculators and unpredictable hot money flows. China may be the second largest economy in the world but it is a developing country and its financial markets are far from deeply developed.

It was only May last year when bank deposit insurance was introduced in China, and October when interest rates for deposits were deregulated. While these measures were expected and perhaps overdue, each phase of financial market deregulation brings adjustment, potential instability and risks. Moving too quickly on liberalisation of financial markets and the capital account is risky and there needs to be time for regulators and financial supervisory bodies to catch up to the market.

So how will the authorities know when the necessary conditions have been met and domestic financial markets are ready for an open capital account?

There is some independent urgency to reform financial markets given the current system effectively keeps consumers and smaller enterprises reliant on the shadow banking system or no system at all — a major brake on the shift towards consumption-based growth. Moving ahead with capital account liberalisation will speed up some of these much-needed reforms and expose the weaknesses in the system that may otherwise not be known. This is the vexed question of how to get the sequence of reforms right.

In the meantime with a crawling peg to the US dollar — neither freely floating or fixed — and a capital account that is not completely closed, the People’s Bank of China (PBoC), China’s central bank, is in an unenviably difficult position.

The US Federal Reserve Bank and the PBoC are moving in opposite directions on monetary policy. The PBoC is pursuing monetary stimulus in an environment where China’s growth is slowing. Capital has been flowing out of China to the United States with the prospects of rising US interest rates as the American economy recovers. That has caused downward pressure on the renminbi (RMB). The expectations of a devaluation (a lowering of the RMB exchange rate) further fuels capital outflows.

As Yu Yongding explains in this week’s feature essay, ‘[t]o 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’.

There is little risk of China undertaking competitive devaluation — reducing the value of the RMB vis-a-vis foreign currencies to boost exports and provide a fillip to the Chinese economy. Certainly rapid devaluation would anger other countries and invite adverse responses, but the main reason to avoid such a move is that it would artificially boost manufacturing exports and hurt consumption. That would fly in the face of the domestic economic rebalancing away from the old export-led growth model that is underway.

To avoid the RMB depreciating against the US dollar too rapidly the PBoC spent half a trillion US dollars of its foreign exchange reserves in 2015 and already close to US$100 billion in January this year. That’s a high price to pay for short term stability and it’s a strategy that will fairly quickly eat into the remaining US$3.2 trillion of foreign exchange reserves.

Bank of Japan Governor Haruhiko Kuroda last month suggested that ‘capital controls would allow Beijing to maintain its foreign exchange reserves’. That would allow the RMB to be stabilised without running down foreign exchange reserves.

Tightening capital controls in the short term would give the PBoC more options on the exchange rate regime, Yu agrees. There are three options, he says: ‘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.’

Whatever the choice, the approach to financial market reform and capital account liberalisation needs to be gradual. Getting the sequencing right and finding the right policy mix will be key, even if it means being willing to go backwards in the short-run and imposing limits on capital movements.

The EAF Editorial Group is comprised of Peter Drysdale, Shiro Armstrong, Ben Ascione, Ryan Manuel and Jillian Mowbray-Tsutsumi and is located in the Crawford School of Public Policy in the ANU College of Asia and the Pacific.