A floor for the yuan

The People’s Bank of China (PBOC) faces a dilemma. After nearly a decade of trying to curb expectations of continued currency appreciation (spurred by China’s current- and capital-account surpluses), it finally succeeded in the first quarter of 2014, when its forceful market intervention drove down the yuan’s exchange rate to discourage carry trades — borrowing money at low interest rates and investing it in a currency with better returns. But now the PBOC is facing an even more difficult challenge, as seemingly irreversible depreciation expectations undermine economic stability when China can least afford more uncertainty.

Because the 2014 intervention coincided with the weakening of China’s economic fundamentals, it ultimately amounted to pushing on an opening door. Instead of providing credible resistance to upward pressure on the exchange rate, as intended, it triggered an outright reversal, with depreciation expectations beginning to creep into foreign-exchange markets.

Thus, in the second quarter of 2014, China recorded a capital-account deficit for the first time in decades. And by the first quarter of last year, that deficit more than offset the current-account surplus, meaning China registered its first international balance-of-payments deficit in recent memory.

Nonetheless, given the size of China’s foreign-exchange reserves, markets were confident the PBOC could fix the yuan exchange rate at whatever level it wanted, regardless of China’s external balance-of-payments position. As a result, depreciation expectations were not strong. Then, last August, the PBOC lowered the yuan central parity rate by 1.9 per cent, perhaps in response to an International Monetary Fund report urging China to align the parity rate more closely with the market rate. The move roiled markets and intensified depreciation fears. The PBOC quickly moved to avert a panic by halting the depreciation, but it was too late: Expectations of further yuan weakening became established in the market.

As these expectations drive an increasing amount of capital out of China, thereby intensifying depreciation pressure, the PBOC continues to intervene in the foreign-exchange market, often in unpredictable ways (in order to discourage speculation). As a result, the PBOC has de facto adopted a crawling-peg exchange-rate regime.

While a crawling-peg system can eliminate short-term depreciation expectations and reduce the associated capital outflows, it cannot eliminate depreciation expectations in the more distant future, let alone reduce capital outflows unrelated to depreciation expectations. In fact, the crawling peg encourages some kinds of capital outflows, such as carry trade unwinding, the dollarisation of household accounts and withdrawal by portfolio investors. Meanwhile, China’s economic fundamentals continue to worsen.

All of this has forced the PBOC to use up more than US$500 billion (S$713 billion) last year alone to keep the level of yuan depreciation vis-a-vis the US dollar within 5 per cent. At this rate, those foreign-exchange reserves will soon be exhausted. That is not an option.

Recognising the challenge at hand, the PBOC has been allowing the yuan to fall, slowly but surely, since November. But while this “stealth devaluation” worked for a while, market participants decided at the beginning of this year to dump their yuan again.

The PBOC now has three options: It can stop all interventions and let the yuan float; link it to a basket of currencies; or peg it tightly to the US dollar, as it did during the Asian financial crisis of 1997. So far, the PBOC has offered no indication of its plans, beyond continuing its yuan-sustaining policy.

The PBOC should reinforce the Chinese government’s market-oriented reform plans and allow the yuan to float. China is still running a large current-account surplus and a long-term capital-account surplus, and it has not fully liberalised its capital account, so the chances are good that the yuan would not fall too far or for too long.

Even if the yuan did have a double-digit depreciation, China would not be thrust into a financial crisis. After all, the country’s stock of corporate external debt is not too large; the currency mismatch within Chinese banks is small; and inflation is just above 1 per cent. To bolster such financial buffers, China must enforce existing capital controls much more strictly.

Yet there remains the possibility of a market panic, with all of the uncertainty such an episode implies. Given this, the PBOC could engineer a transition where the yuan is pegged to a basket of currencies, with an adjustable central parity rate and a wide fluctuation band of 7.5 per cent or even 15 per cent. It could choose not to announce the (very wide) fluctuation band, so that investors, judging that the yuan had fallen far enough, might begin to purchase the currency before it actually reached the floor. This would stabilise the exchange rate before the PBOC was forced to spend more foreign-exchange reserves.

This year will be another difficult one for China. But the situation is far from dire. With the right policies, China should be able to stabilise its currency and foreign-reserve position, and return to sustainable growth.

ABOUT THE AUTHOR:

Yu Yongding, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People’s Bank of China from 2004 to 2006.