CHINA
25 March 2016
China facing the exchange rate policy dilemma
China has entered the trilemma of open macroeconomic policy — independent monetary policy, capital mobility, and a fixed exchange rate cannot be achieved simultaneously, argues Yuqing Xing.
Since last summer, China’s exchange rate policy has turned into a critical source of global financial market instability. On August 11, 2015, the People’s Bank of China (PBoC) unexpectedly cut its daily midpoint rate by 1.9 percent, the largest one-day drop of the RMB since China ended the dual-currency in 1994. The PBoC issued an official statement to justify its action.
It explained that the change was intended to improve the determination mechanism of the RMB’s exchange rates and to align the daily midpoint rate to the conditions of demand and supply. In the following three days, the RMB further depreciated 3 percent. The sudden depreciation of the RMB triggered turbulence in global financial markets including Tokyo, London, and New York. All major financial markets responded with a sharp fall.
This was the first time the adjustment of China’s macroeconomic policy shocked the global financial market. Worried about the unsettled volatility of domestic stock markets and the negative spillover effects on foreign financial markets, the PBoC gave up the market-oriented reform of the formulation of RMB’s exchange rates and started heavy intervention in both onshore and offshore markets of the RMB by selling the US dollar.
It was estimated that in August 2015 the PBoC spent at least USD 100 billion to halt the slide of the RMB. Moreover, to calm the anxiety of foreign currency traders and hopefully reverse prevailing market expectations, China’s President Xi Jinping reiterated during his state visit to the US that there was no basis for the continuous depreciation of the RMB. Finally, the intensive intervention of the PBOC stabilized the exchange rate of the RMB around RMB 6.5 per USD.
However, on January 6, just a few days after entering 2016, the PBoC shocked the market again by setting the midpoint rate at RMB 6.5646 per USD, the lowest since March 2011. The RMB continued its slide in the following trading days and fell to RMB 6.5972 per USD dollar in the onshore market and a record low of RMB 6.7600 per USD in the offshore market. The spillover of the RMB’s depreciation triggered a new round of selloffs in international financial markets. To prevent the RMB from further falling, the PBoC intensified its defense of the RMB. The intervention almost dried up the liquidity of the RMB in the offshore market of Hong Kong. It was rumored that Chinese commercial banks in Hong Kong were ordered by the PBoC not to provide RMB loans to suspicious speculators.
Once again, the Chinese government attempted to ease the nervousness of the markets by repeating the same message — there was no basis for the persistent depreciation of the RMB. Recently when the finance ministers and central bank governors of the G-20 gathered in Shanghai, Chinese Premier Li Keqiang pledged that China would not participate in currency wars and has no plan to revitalize its exports through devaluation. The contradictory actions of the PBoC indicate that the Chinese government has been facing the dilemma of whether or not to let the RMB depreciate. Unambiguously, speculators who bet on the RMB’s depreciation have been winners so far.
From August 2015 to January 2016, the newly introduced mechanism of setting daily midpoint rates and the public statements by the PBoC and Chinese leaders were inconsistent and confused both domestic and international investors. The inconsistency undermined the credibility of China’s exchange rate policy and raised doubts on the ability of Chinese policy makers to effectively communicate with markets and maintain the stability of the Chinese economy, which has been deeply integrated with the world economy through trade and capital flows.
The public statements of the no-depreciation policy and the heavy intervention of the PBoC actually failed to mitigate the depreciation expectations. The confusing signals observed by market participants actually further strengthened their depreciation expectations on the RMB. George Soros, the famous/infamous hedge fund manager openly told a reporter at Davos that he shorted the RMB. Many Wall Street hedge fund managers also joined the game and bet against the PBoC. Shorting the RMB was considered as a sure-bet.
Whenever the RMB depreciated against the USD, Chinese policy makers blamed unscrupulous speculators and argued vehemently that there was no basis for the long-term depreciation of the RMB. The detailed examination of the evolution of both Chinese and US monetary policies in the last two years, however, unequivocally suggests that the RMB has been facing a pressure of depreciation in the short-run. According to economic theory, interest rate parity determines the equilibrium of exchange rates in the short-run. The divergence of monetary policies between China and the US broke the original interest rate parity. The adjustment of the RMB’s exchange rate is required to achieve new interest rate parity.
In October 2014, the US officially exited quantitative easing, the non-traditional monetary policy adopted by the US Federal Reserve to combat the great recession following the bursting of the housing bubble in 2008. In December 2015, the US Federal Reserve raised the interest rate to 0.25 percent from zero, the beginning of a new cycle of rising interest rates. In contrast, China entered a cycle of declining interest rate in November 2014, when the PBoC cut the one-year deposit rate to 2.75 percent from 3.0 percent to support the growth of the Chinese economy. So far, the PBoC has cut interest rates five times.
Clearly, the USD return has been rising while that of the RMB has been decreasing, which raises the demand for USD denominated assets and erodes the demand for RMB denominated assets. In other words, in the foreign exchange market, orders for selling RMB for the USD are higher than that of buying RMB. It requires the depreciation of the RMB to reach a new equilibrium where the demand and supply of RMB assets would be balanced. Before August 2015, except for the RMB, all currencies depreciated against the US dollar after the US Federal Reserve exited from the QE. It is the invisible hand that has been driving the depreciation of the RMB. All the speculators who expected the RMB to fall were simply smart enough to foresee the trend ahead of the curve.
China’s trade surplus has been cited as evidence to rebuff the depreciation argument. It is true that China still maintains a handsome surplus of USD 350 billion in trade in goods and services last year. China has recorded no monthly trade deficit. Currencies function not only as mediums of transaction but also as stores of value. In other words, currencies are an asset. Expected arbitrage opportunities drive the demand and supply of currencies in foreign exchange markets. The daily volume of transactions in foreign exchange markets exceed USD 5 trillion, most of which have nothing to do with trade in goods and services but reflect portfolio investment demand. Hence, the volatility of exchange rates is more affected by capital flows rather than flows of goods.
Simply focusing on trade is too narrow to understand correctly the mechanism of exchange rate determination. In 2015, China’s foreign exchange reserve fell USD 590 billion. Given USD 350 billion surplus in trade and USD 121 billion inflows of FDI, total capital outflows from China is estimated to have exceeded USD 1.0 trillion. The capital inflows brought by the trade surplus and FDI are far below the capital outflows, which have nothing to do with trade in goods and services.
Purchasing power parity determines the equilibrium of exchange rates in the long run. The purchasing power of a currency has a negative relationship with the money supply. China’s 4 trillion stimulus, implemented by the Chinese government to counterbalance the shock of the global financial crisis and the subsequent credit expansions has greatly bloomed the money supply of the Chinese economy, pushing broad money supply M2 of 2015 beyond 200 percent of China’s GDP, much higher than 70 percent of the US economy. The purchasing power of the RMB has been eroded relative to the USD. The buying frenzy of Chinese tourists in Japan and the seemingly unsaturated appetite of Chinese investors for foreign real estate are evidence that the RMB has been overvalued, not only to the dollar, but also to the Euro and the Japanese Yen.
In a closed economy, it is possible to maintain a fixed exchange rate regime. For an economy like China, which every year trades about USD 4 trillion in goods and services with the rest of the world and has a liberalized current account, it is almost impossible to maintain the very rigid managed floating system, which allows a narrow band of 2 percent around the midpoint set up by the PBoC. In fact, China has entered the trilemma of open macroeconomic policy — independent monetary policy, capital mobility, and a fixed exchange rate cannot be achieved simultaneously and any combination of two policy objectives implies the third is impossible.
The trilemma is true, regardless of the size of an economy. As the second largest economy with more than USD 10 trillion in GDP, China cannot afford to lose the independence of monetary policy. A series of interest rate cuts since September 2014 and a recent cut on the required reserve ratio of commercial banks indicate that monetary policy remains an indispensable tool to stimulate the growth of the Chinese economy. On the other hand, the intervention of the PBoC in the foreign exchange markets actually sterilized the monetary expansion induced by the decrease in the interest rate.
To defend the RMB, the PBoC should sell the USD. Whenever USD 100 billion is sold, China’s monetary basis will decrease by RMB 650 billion accordingly, assuming that the exchange rate is RMB 6.5 per dollar. The broad money supply may fall more than 3.0 trillion if the velocity of the RMB’s circulation is 5. Since August 2015, the foreign exchange reserve of the PBoC has decreased at a pace of USD 100 billion per month.
Continuous intervention not only depletes the foreign exchange reserve, but more importantly undermines the autonomy of monetary policy and counterbalances expected effects of the interest rate cut. As the stock of the foreign exchange reserve gradually shrinks, the ammunition the PBoC can use to stabilize the exchange rate of the RMB will become less, which may further strengthen the belief that the PBoC will eventually give up its intervention, like all the central banks in the past which attempted to defend their currencies and ended up with a sharp depreciation.
Exchange rate policy is an integral part of macroeconomic policy, which should ensure stable economic growth. China’s economic growth fell to 6.9 percent in 2015, the lowest since 2000. The “new economic normal” may explain a part of the slowdown. The fall of export growth from more than 20 percent to -2.8 percent within the five year period from 2010 to 2015 cannot be arbitrarily attributed to the “new economic normal.” It is definitely abnormal. Exports had been one of three growth engines driving the Chinese economy during its high growth period. It contributed 1/3 to the growth of the Chinese economy from 2001 to 2007. Now the engine of exports has lost steam completely. The significance of exports cannot be compensated by moderate growth in consumption. Rebalancing the Chinese economy from export-oriented to domestic consumption-oriented is easier said than done. The rebalancing proposal ignores the rigid economic structure which had been established under the export-oriented growth strategy.
The over-valuation of the RMB is the most critical factor undercutting the growth momentum of exports. Since July 2005, the RMB has appreciated against the USD more than 35 percent nominally. Given the inflation disparity between China and the US, the real appreciation of the RMB is much higher. In addition, since the RMB is basically pegged to the USD, the sharp depreciation of other currencies such as the Japanese Yen and Euro against the USD in recent years has automatically triggered passive appreciation of the RMB against all these currencies. Most of Chinese exports are priced in the USD and Chinese exporters have no pricing power.
It is impossible for Chinese exporters to pass the cost of RMB’s appreciation to foreign buyers. They have to absorb the cost internally and cope with declining profit margins. Eventually, some exporters lost their competitiveness and exited. Further, processing exports, which have razor-thin profit margins, are also a victim of the over-valuation. Processing exports used to account for more than 50 percent of China’s exports. The appreciation of the RMB has driven a rapid growth of Chinese workers’ wages measured in the USD, thus forcing multinational enterprises to relocate their assembly tasks to third countries with lower wages, such as India and the South East Asian countries. The relocation has undercut China’s export capacity. Therefore, besides sluggish external demand, the exit of domestic firms and the exodus of foreign investors because of the cumulative appreciation of the RMB have contributed substantially to the tumble of China’s export growth.
Letting the RMB follow market expectations and depreciate will not only free China from the trilemma, but more importantly give a desperately needed boost to economic growth. A robust Chinese economy is far more important to the world than a struggling economy with a fixed exchange rate.
This article was first published by the IPP Review on March 23, 2016.
It explained that the change was intended to improve the determination mechanism of the RMB’s exchange rates and to align the daily midpoint rate to the conditions of demand and supply. In the following three days, the RMB further depreciated 3 percent. The sudden depreciation of the RMB triggered turbulence in global financial markets including Tokyo, London, and New York. All major financial markets responded with a sharp fall.
This was the first time the adjustment of China’s macroeconomic policy shocked the global financial market. Worried about the unsettled volatility of domestic stock markets and the negative spillover effects on foreign financial markets, the PBoC gave up the market-oriented reform of the formulation of RMB’s exchange rates and started heavy intervention in both onshore and offshore markets of the RMB by selling the US dollar.
It was estimated that in August 2015 the PBoC spent at least USD 100 billion to halt the slide of the RMB. Moreover, to calm the anxiety of foreign currency traders and hopefully reverse prevailing market expectations, China’s President Xi Jinping reiterated during his state visit to the US that there was no basis for the continuous depreciation of the RMB. Finally, the intensive intervention of the PBOC stabilized the exchange rate of the RMB around RMB 6.5 per USD.
However, on January 6, just a few days after entering 2016, the PBoC shocked the market again by setting the midpoint rate at RMB 6.5646 per USD, the lowest since March 2011. The RMB continued its slide in the following trading days and fell to RMB 6.5972 per USD dollar in the onshore market and a record low of RMB 6.7600 per USD in the offshore market. The spillover of the RMB’s depreciation triggered a new round of selloffs in international financial markets. To prevent the RMB from further falling, the PBoC intensified its defense of the RMB. The intervention almost dried up the liquidity of the RMB in the offshore market of Hong Kong. It was rumored that Chinese commercial banks in Hong Kong were ordered by the PBoC not to provide RMB loans to suspicious speculators.
Once again, the Chinese government attempted to ease the nervousness of the markets by repeating the same message — there was no basis for the persistent depreciation of the RMB. Recently when the finance ministers and central bank governors of the G-20 gathered in Shanghai, Chinese Premier Li Keqiang pledged that China would not participate in currency wars and has no plan to revitalize its exports through devaluation. The contradictory actions of the PBoC indicate that the Chinese government has been facing the dilemma of whether or not to let the RMB depreciate. Unambiguously, speculators who bet on the RMB’s depreciation have been winners so far.
From August 2015 to January 2016, the newly introduced mechanism of setting daily midpoint rates and the public statements by the PBoC and Chinese leaders were inconsistent and confused both domestic and international investors. The inconsistency undermined the credibility of China’s exchange rate policy and raised doubts on the ability of Chinese policy makers to effectively communicate with markets and maintain the stability of the Chinese economy, which has been deeply integrated with the world economy through trade and capital flows.
The public statements of the no-depreciation policy and the heavy intervention of the PBoC actually failed to mitigate the depreciation expectations. The confusing signals observed by market participants actually further strengthened their depreciation expectations on the RMB. George Soros, the famous/infamous hedge fund manager openly told a reporter at Davos that he shorted the RMB. Many Wall Street hedge fund managers also joined the game and bet against the PBoC. Shorting the RMB was considered as a sure-bet.
Whenever the RMB depreciated against the USD, Chinese policy makers blamed unscrupulous speculators and argued vehemently that there was no basis for the long-term depreciation of the RMB. The detailed examination of the evolution of both Chinese and US monetary policies in the last two years, however, unequivocally suggests that the RMB has been facing a pressure of depreciation in the short-run. According to economic theory, interest rate parity determines the equilibrium of exchange rates in the short-run. The divergence of monetary policies between China and the US broke the original interest rate parity. The adjustment of the RMB’s exchange rate is required to achieve new interest rate parity.
In October 2014, the US officially exited quantitative easing, the non-traditional monetary policy adopted by the US Federal Reserve to combat the great recession following the bursting of the housing bubble in 2008. In December 2015, the US Federal Reserve raised the interest rate to 0.25 percent from zero, the beginning of a new cycle of rising interest rates. In contrast, China entered a cycle of declining interest rate in November 2014, when the PBoC cut the one-year deposit rate to 2.75 percent from 3.0 percent to support the growth of the Chinese economy. So far, the PBoC has cut interest rates five times.
Clearly, the USD return has been rising while that of the RMB has been decreasing, which raises the demand for USD denominated assets and erodes the demand for RMB denominated assets. In other words, in the foreign exchange market, orders for selling RMB for the USD are higher than that of buying RMB. It requires the depreciation of the RMB to reach a new equilibrium where the demand and supply of RMB assets would be balanced. Before August 2015, except for the RMB, all currencies depreciated against the US dollar after the US Federal Reserve exited from the QE. It is the invisible hand that has been driving the depreciation of the RMB. All the speculators who expected the RMB to fall were simply smart enough to foresee the trend ahead of the curve.
China’s trade surplus has been cited as evidence to rebuff the depreciation argument. It is true that China still maintains a handsome surplus of USD 350 billion in trade in goods and services last year. China has recorded no monthly trade deficit. Currencies function not only as mediums of transaction but also as stores of value. In other words, currencies are an asset. Expected arbitrage opportunities drive the demand and supply of currencies in foreign exchange markets. The daily volume of transactions in foreign exchange markets exceed USD 5 trillion, most of which have nothing to do with trade in goods and services but reflect portfolio investment demand. Hence, the volatility of exchange rates is more affected by capital flows rather than flows of goods.
Simply focusing on trade is too narrow to understand correctly the mechanism of exchange rate determination. In 2015, China’s foreign exchange reserve fell USD 590 billion. Given USD 350 billion surplus in trade and USD 121 billion inflows of FDI, total capital outflows from China is estimated to have exceeded USD 1.0 trillion. The capital inflows brought by the trade surplus and FDI are far below the capital outflows, which have nothing to do with trade in goods and services.
Purchasing power parity determines the equilibrium of exchange rates in the long run. The purchasing power of a currency has a negative relationship with the money supply. China’s 4 trillion stimulus, implemented by the Chinese government to counterbalance the shock of the global financial crisis and the subsequent credit expansions has greatly bloomed the money supply of the Chinese economy, pushing broad money supply M2 of 2015 beyond 200 percent of China’s GDP, much higher than 70 percent of the US economy. The purchasing power of the RMB has been eroded relative to the USD. The buying frenzy of Chinese tourists in Japan and the seemingly unsaturated appetite of Chinese investors for foreign real estate are evidence that the RMB has been overvalued, not only to the dollar, but also to the Euro and the Japanese Yen.
In a closed economy, it is possible to maintain a fixed exchange rate regime. For an economy like China, which every year trades about USD 4 trillion in goods and services with the rest of the world and has a liberalized current account, it is almost impossible to maintain the very rigid managed floating system, which allows a narrow band of 2 percent around the midpoint set up by the PBoC. In fact, China has entered the trilemma of open macroeconomic policy — independent monetary policy, capital mobility, and a fixed exchange rate cannot be achieved simultaneously and any combination of two policy objectives implies the third is impossible.
The trilemma is true, regardless of the size of an economy. As the second largest economy with more than USD 10 trillion in GDP, China cannot afford to lose the independence of monetary policy. A series of interest rate cuts since September 2014 and a recent cut on the required reserve ratio of commercial banks indicate that monetary policy remains an indispensable tool to stimulate the growth of the Chinese economy. On the other hand, the intervention of the PBoC in the foreign exchange markets actually sterilized the monetary expansion induced by the decrease in the interest rate.
To defend the RMB, the PBoC should sell the USD. Whenever USD 100 billion is sold, China’s monetary basis will decrease by RMB 650 billion accordingly, assuming that the exchange rate is RMB 6.5 per dollar. The broad money supply may fall more than 3.0 trillion if the velocity of the RMB’s circulation is 5. Since August 2015, the foreign exchange reserve of the PBoC has decreased at a pace of USD 100 billion per month.
Continuous intervention not only depletes the foreign exchange reserve, but more importantly undermines the autonomy of monetary policy and counterbalances expected effects of the interest rate cut. As the stock of the foreign exchange reserve gradually shrinks, the ammunition the PBoC can use to stabilize the exchange rate of the RMB will become less, which may further strengthen the belief that the PBoC will eventually give up its intervention, like all the central banks in the past which attempted to defend their currencies and ended up with a sharp depreciation.
Exchange rate policy is an integral part of macroeconomic policy, which should ensure stable economic growth. China’s economic growth fell to 6.9 percent in 2015, the lowest since 2000. The “new economic normal” may explain a part of the slowdown. The fall of export growth from more than 20 percent to -2.8 percent within the five year period from 2010 to 2015 cannot be arbitrarily attributed to the “new economic normal.” It is definitely abnormal. Exports had been one of three growth engines driving the Chinese economy during its high growth period. It contributed 1/3 to the growth of the Chinese economy from 2001 to 2007. Now the engine of exports has lost steam completely. The significance of exports cannot be compensated by moderate growth in consumption. Rebalancing the Chinese economy from export-oriented to domestic consumption-oriented is easier said than done. The rebalancing proposal ignores the rigid economic structure which had been established under the export-oriented growth strategy.
The over-valuation of the RMB is the most critical factor undercutting the growth momentum of exports. Since July 2005, the RMB has appreciated against the USD more than 35 percent nominally. Given the inflation disparity between China and the US, the real appreciation of the RMB is much higher. In addition, since the RMB is basically pegged to the USD, the sharp depreciation of other currencies such as the Japanese Yen and Euro against the USD in recent years has automatically triggered passive appreciation of the RMB against all these currencies. Most of Chinese exports are priced in the USD and Chinese exporters have no pricing power.
It is impossible for Chinese exporters to pass the cost of RMB’s appreciation to foreign buyers. They have to absorb the cost internally and cope with declining profit margins. Eventually, some exporters lost their competitiveness and exited. Further, processing exports, which have razor-thin profit margins, are also a victim of the over-valuation. Processing exports used to account for more than 50 percent of China’s exports. The appreciation of the RMB has driven a rapid growth of Chinese workers’ wages measured in the USD, thus forcing multinational enterprises to relocate their assembly tasks to third countries with lower wages, such as India and the South East Asian countries. The relocation has undercut China’s export capacity. Therefore, besides sluggish external demand, the exit of domestic firms and the exodus of foreign investors because of the cumulative appreciation of the RMB have contributed substantially to the tumble of China’s export growth.
Letting the RMB follow market expectations and depreciate will not only free China from the trilemma, but more importantly give a desperately needed boost to economic growth. A robust Chinese economy is far more important to the world than a struggling economy with a fixed exchange rate.
Acknowledgements
Yuqing Xing is a Professor of Economics and the Director of Asian Economic Policy at the National Graduate Institute for Policy Studies, Japan.This article was first published by the IPP Review on March 23, 2016.