China’s Currency Woes
China has been making a protracted effort to liberalize both its currency and its capital account in the past few years. Now that the renminbi (RMB) is dropping, foreign reserves are running out, and capital outflow is picking up, it’s not certain that this reform policy can continue. Is China going to forge ahead or enter a more conservative cycle and wait for the markets to calm down? In our opinion, either possibility would have both good and bad points.
The policymakers that pull the strings of the Chinese economy are facing a troubling picture. The RMB has grown significantly more volatile in the last two years. More capital is leaving the country, and China’s foreign reserves are lower than ever. Current reserves are fully $663 billion below their high point in mid-2014. This money has been used to try and check the slide of the RMB through market intervention.
All of this means that Beijing is now staring into the depths of the “impossible trinity” problem. To state it in blunt terms, a government can’t exercise strict control over exchange rates and interest rates while also letting capital flow freely.
With free-flowing capital, a national government has to pick between holding exchange rates steady or maintaining its own independent interest rates. When the exchange rate is fixed, interest rates have to follow worldwide trends. Set interest rates force the government to let its exchange rates float. The flow of funds in and out of the country will set the rate in this case.
Of course, it is possible to take a firm grasp on both the exchange rates and the nation’s interest rates. A nation exercising this level of control can’t keep a capital account open, though.
In a three-part system where at least part has to be left free, clamping down on all three is a recipe for disaster. When we look back at China’s financial history, it’s clear that the country has preferred to dictate its own terms when it comes to domestic monetary policy. This was easy when both the capital account and the currency were more or less fixed, but now?
Give Up Liberalization Or Accept Depreciation?
Today Beijing’s string-pullers are trying to liberalize both the capital account and the currency. The results will not be favorable as long as capital continues flowing out of China. They can let the RMB’s value depreciate on its own, they can close off their capital account, or they can haul up interest rates to protect the RMB (while also putting a halt to economic growth).
China has always preferred gradual financial changes to huge leaps. When their foreign reserves topped the US $4 billion mark, they certainly appeared to have the resources they would need to dictate the pace of liberalization. The volatility we’re seeing in global markets right now, though, is a clear sign that the global repercussions of liberalization (the so-called “China impact”) weren’t taken into account. Now observers are watching Beijing attempt to counteract their capital outflows by releasing huge chunks of their foreign exchange reserve with mounting trepidation.
Tracking those reserves closely reveals some troubling signs that a rise in interest rates may well be inevitable due to the loss of domestic liquidity. In earlier economic conditions, with foreign capital rushing into the country, China could easily meet its reserve ratio target (17 percent). Now that the system is effectively running in reverse, that liquidity is being spent to make up for the money leaving the country.
If China is going to bow to the demands of the global market, it will have to finally let the RMB float. The alternative is enacting capital controls (under the charming euphemism of “macroprudential measures”) to try and stem the outward flow of capital. Either option will have consequences both inside and outside China.
Depreciating the RMB could cause its value to fall even lower than expected in an uncertain market. There are some who question the wisdom of devaluation to make Chinese exports more competitive in the face of sluggish demand in all parts of the world. Singapore, Taiwan, and South Korea have all attempted to boost exports in the past year through currency depreciation; the results have been underwhelming.
Depreciation subjects Chinese corporations to increased risk, too. Many of them assumed offshore debt assuming that the RMB would remain stable. The overall utility of macroprudential measures is debatable, even though China wouldn’t be the first country to employ them. Risks include contradicting China’s professed interest in free-market economics. If the measures are successful, though, the reform effort can be resumed when conditions become favorable.
Rosier De-Liberalization Prospects
We don’t expect the People’s Bank of China to start depreciating the RMB against either the US Dollar specifically or other currencies in general. Such a move would hurt the RMB’s potential as a reserve currency. The central bank has been emphasizing the RMB’s relative stability against a broad basket of currencies as a contrast to the ongoing volatility in the USD / RMB exchange rate.
From what we’re seeing, we believe it’s clear that the PBC intends to slow down the pace of liberalization. It’s already set a three-month moratorium on foreign exchange transactions by foreign banks. Citizens leaving China have also had their currency export allowance cut down to RMB 50,000. The PBC may also attempt to bring the offshore and onshore markets closer in line with each other through direct intervention.
We’re forecasting continued stability of the RMB compared to its currency basket. The current upwards trend in the USD will likely end within the year. A slight uptick should bring CNY / USD to 6.6 within six months. We expect continued volatility in the CNY’s value compared to CNH / USD, but the deviations should be limited by the PBC’s actions.