Date
15 December 2017
The Chinese currency will gain excessive strength in tandem with the greenback and the Chinese unit may risk falling sharply if it does not strengthen with the US dollar. Photo: HKEJ
The Chinese currency will gain excessive strength in tandem with the greenback and the Chinese unit may risk falling sharply if it does not strengthen with the US dollar. Photo: HKEJ

Why RMB should be linked to currency basket, not dollar

China should adjust its foreign exchange reserve management to link the renminbi to a basket of currencies given that the US dollar is on a strong upward trajectory.

A substantial portion of foreign exchange reserves in Hong Kong and China has been invested in US government debt with long duration.

As US yields spike, government debt prices may drop by 30 to 50 percent. That would lead to huge losses for these foreign exchange reserve assets.

The State Administration of Foreign Exchange should learn from the Singapore experience.

Singapore switched part of its US government bond holding into other US dollar assets such as blue-chip stocks and commercial buildings.

The switch not only mitigates future losses or generates lucrative profit but also optimizes the system of managing foreign exchange reserves.

Assuming the US dollar will gain at least 30 percent against major currencies, the renminbi might also pick up that amount if the government keeps the exchange rate against dollar stable or allow gradual appreciation.

That would not only hurt Chinese exports and economic growth but also expose the Chinese currency to high risks of shock and sharp declines.

If the current exchange rate is close to the long-term equilibrium, the renminbi will appreciate by about 30 percent against other major currencies if authorities intend to defend the exchange rate with the dollar.

The central bank will be forced to let the renminbi depreciate sharply due to an overly high exchange rate.

If that happens, massive illegal capital will flee the country. That, coupled with contracting liquidity and economic slowdown, will lead to plunging property and stock prices and a spike in the unemployment rate.

The passive depreciation of the renminbi may trigger severe financial crisis as happened in Thailand, Indonesia and South Korea in 1997.

China’s central bank should not defend the exchange rate with US dollar now and in coming years.

That would put the renminbi in a dilemma. The Chinese currency will gain excessive strength in tandem with the greenback and the Chinese unit may risk falling sharply if it does not strengthen with the US dollar.

In this case, the central bank should link its foreign exchange reserves to a basket of currencies.

The exchange rate against the basket will be determined by the weighting of trade with different nations.

That would help shelter China’s exports from external fluctuations of other major currencies such as the greenback or the euro.

At present, the Singapore dollar is depreciating against the US dollar but appreciating against other currencies, which offsets the impact — and exerts limited impact — on its export sector.

The currency basket exchange rate system is quite sensible for China.

By contrast, the Hong Kong dollar is pegged to the US dollar. A strong greenback in the years ahead will hurt Hong Kong’s economy.

Moreover, a property bubble is very likely to burst between 2016 and 2018 amid rising interest rates and a stronger dollar.

If so, that could lead to another round of financial crises in Asia and damage China’s economy.

China’s central bank should repeatedly tell the market it has adopted a currency basket regime in its foreign exchange rate management just as Singapore did when it made the switch.

The US dollar will be the strongest currency in coming years, supported by US economic recovery and rising US yields.

And the greenback will be sought-after as a safe heaven once Hong Kong’s property bubble bursts and another Asia financial crisis emerge.

Investors should avoid emerging market assets, Hong Kong and Asian property and switch to US stocks and property.

This article appeared in the Hong Kong Economic Journal on Jan. 29.

Translation by Julie Zhu

– Contact us at [email protected]

JZ/JP/RA

Associate Professor, Division of Economics, School of Humanities and Social Sciences at Nanyang Technological University

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