The recent decline of the yuan exchange rate against the US dollar is not large, and as I have argued in this column on Feb. 28, the Chinese currency’s fundamentals are still pointing to appreciation, albeit with increasing volatility, over the medium term. But the decline is striking by the standards of what is still a heavily managed currency, and it is in the opposite direction from what the market has been expecting for a long time.
The US Federal Reserve’s tapering of its quantitative easing policy has had some effect on weakening the renminbi — and other emerging market currencies — by unwinding the so-called carry trade. This is a typical strategy for investors with access to Chinese financial markets to borrow dollars at low interest rates and swap the dollars into yuan to buy high-yield Chinese assets. But tapering has pushed up US yields and made it more expensive to borrow dollars and invest in Chinese assets. As this carry trade falls out of favor, demand for yuan declines and its exchange rate depreciates.
However, the Fed’s policy impact is only a sideshow in the grand scheme of things. The reality is that China’s tightly controlled currency falls only when the People’s Bank of China (PBoC) allows it to fall. It is the PBoC, not the Fed, that determines the direction of the renminbi’s movement.
So why is the PBoC so keen on devaluing the yuan?
One paradoxical reason is that a weaker yuan is part of Beijing’s grand strategy to internationalize its currency, starting with broadening the yuan’s role for foreign trade and investment-related purposes. Eventually, it would like to see the renminbi achieve an international status as an official reserve currency, for example.
To do that, China will have to open its financial markets to foreign participants. But a one-way bet on yuan appreciation stands in the way of opening the Chinese markets to market forces by building excessive speculation. So long as investors believe that the yuan can only go up, opening China’s capital market will invite massive hot money inflows, with unpleasant financial consequences including inflation.
Investors need to be reminded that the yuan can fall as well as rise. Squashing speculators’ one-way bet on yuan appreciation thus signals a policy shift by the PBoC towards a freer exchange rate regime. Adjust the currency’s trading band should be a medium-term step towards the eventual goal of a floating exchange rate.
History teaches us that the combination of open financial markets and a rigid exchange rate is a recipe for financial disaster. China has begun opening its financial markets. Thus, greater exchange-rate flexibility is a logical step to go with financial reforms.
Another reason relates to the macroeconomic balancing that Beijing needs to achieve alongside its economic restructuring efforts. To rein in excesses in China’s property and shadow banking markets, the PBoC has sharply curtailed the flow of cheap credit in order to force the system to deleverage. This has caused a sharper than expected slowdown in domestic growth.
Beijing’s dilemma is that too much reform will kill growth, but too much growth will erode the reform incentive. Recent official efforts to clamp down on shadow banking and corruption have shown that Beijing could not engineer an economic soft landing as it had expected. A weak yuan policy has become the balancing tool for boosting economic growth under the deflationary drag of structural reforms.
With China’s capital account still closed, the PBoC can still control both domestic interest rates and the exchange rate. But it has chosen to exit financial repression by gradually letting go of interest rate control while reining in financial excesses. The exchange rate has become the only policy tool it can employ to boost growth to facilitate structural reforms.
Under the current situation of a balance of payments surplus, the PBoC’s devaluation policy could be very effective in boosting growth. To overcome the underlying appreciation pressure on the currency, it has to flood the system with a massive amount of yuan to force down the exchange rate. This liquidity spill-over from the foreign exchange intervention to the domestic system will augment the devaluation effect on Chinese exports to boost economic growth.
However, this policy will not sit well with China’s foreign competitors. Complaints about currency manipulation and the associated diplomatic tensions will quickly return. From China’s perspective, more fluctuation of yuan trading would signal Beijing’s determination to end one-way yuan bets and move on with yuan’s internationalization.
If devaluation is only temporary, it could help balance growth with structural reforms. But if Beijing returns to its old habit of pursuing an undervalued currency, it would indicate a weakening of the reform resolve and that rebalancing has stalled.
For now, Beijing still deserves the benefit of the doubt that its prime goal is to push through economic restructuring but it needs a temporary growth boost to facilitate the process.
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