To Accomplish the Unaccomplished Reform: Lessons and Options of RMB Exchange Rate Reform

YuYongding(余永定)andXiaoLisheng(肖立晟)

China Economist - - Articles - 1 2 Yu Yongding ( ) and Xiao Lisheng ( )余永定 肖立晟1 Chinese Academy of Social Sciences (CASS), Beijing, China 2 Institute of World Economics and Politics, CASS * Corresponding author: Xiao Lisheng, F15, No.5, Jianguomen Nei Avenue, Dongcheng District, B

Abstract: The exchange rate reform initiated on August 11, 2015 is an important attempt by the PBoC to transform China’s exchange rate regime from the “crawl-like arrangement” to a floating regime. However, after a three-day experiment, the PBoC abandoned the original goal of the reform. Since then, the central bank has implemented a new exchange rate-setting mechanism. Under this mechanism, the central parity of the renminbi (RMB) against the US dollar is decided by the arithmetic average of the RMB exchange rate that keeps the index of a currency basket unchanged over the past 24 hours and the previous day’s closing price of USD/ CNY. Due to the introduction of the index of a currency basket, additional uncertainty has been introduced into the determination of the RMB exchange rate, because of the uncertainty of the dollar index (USDX). As a result, to a certain extent, the one-way bet on the RMB expectations is weakened. However, the current exchange rate formation mechanism cannot reverse the trend of devaluation of the RMB, nor can it eliminate depreciation expectations. Meanwhile, it hinders the effectiveness of central bank’s independent monetary policy based on the domestic economic fundamentals. And also, the “two-way float” created by the new price-setting mechanism is artificial and has led to significant losses of foreign exchange reserve. The paper explains how the new price-setting mechanism works, and identifies the important features of the mechanism and its pros and cons. The paper argues that despite some advantages, the new exchange rate regime as a soft peg regime is not sustainable and the PBoC should stop foreign exchange market intervention as soon as possible. We hope that the PBoC can learn the lessons from the failure of the “August 11 reform” and accomplish the unaccomplished reform in an urgent manner.

Keywords:

“August 11 reform”, reform of the RMB exchange rate regime, intervention in the foreign exchange market, currency basket

JEL Classification: F31, F32, F38

1. Evolution of China’s Exchange Rate System after the “August 11 Reform”

By official definition, China’s exchange rate system is a “managed floating regime based on market supply and demand with reference to a basket of currencies.” But according to

the International Monetary Fund documents, there is no “managed floating” category after 2009. Exchange rate systems are reclassified into three broad categories: hard pegs, soft

pegs, and floating regimes. Each category is subdivided into different subcategories. The Chinese exchange rate system is called a “crawllike arrangement” in IMF documents. Under this exchange rate regime, local currency tracks a discernible trend against the US dollar or a basket of currencies with a 2% band.

China’s exchange rate system has evolved over the past three decades. According to the IMF, from the Asian financial crisis in 1997 to the Chinese exchange rate system reform in 2005, China adopted a conventional peg to the US dollar. Since July 21, 2005, the RMB de- pegged from the dollar, and China adopted a regime of crawling peg to the dollar. From August 2008 to June 2010, China re-pegged the RMB to the dollar due to the global financial crisis, which the IMF classifies as a stabilized arrangement, because of the specific time period and the understandable motivation for pegging the RMB to the dollar.

Since June 2010, despite some short-lived depreciation, the RMB resumed the trend of appreciation against the dollar. By April 2011, the RMB appreciated by 4.7% 1. In April 2012, the band of RMB’s volatility increased from 0.5% to 1%; in March, 2014, it further expanded to 2%. As the RMB’s central parity rate changed slowly and the band of crawling did not exceed 2% (Figure 1 and 2), the IMF classified China’s exchange rate regime after June 2010 as “crawl- like arrangement” in Annual Report on Exchange Arrangements and Exchange Restriction 20112 and subsequent reports till 20153. How many countries in the world have adopted a crawl- like arrangement? Not many. According to IMF, there were a total of 12 countries in 2014, and 19 countries in 20154. Except Switzerland and Argentina, the rest are

financially weak countries like Haiti, Dominican Republic, Kazakhstan and Laos. However, Switzerland and Argentina actually opted out of the arrangement in 2015. Hence, it is not an exaggeration to say that all developed and major developing countries ( including India, Brazil, South Africa and Southeast Asian countries) adopt a floating exchange rate system.

“August 11 Exchange Rate Reform” and Follow-Up Changes

However, after the “August 11 reform” in 2015, the situation changed. A rule was introduced for setting USD/CNY central parity rate on August 11, 2015. According to the rule, the central parity rate should be set “with reference to the previous day’s closing price” and the deviation of the current closing price to the current central parity rate should be within a band of ±2%. The RMB started to depreciate against the US dollar. Since then, the RMB has devalued by more than 7 percent. Now the exchange rate of the RMB is hovering around 6.9 (1 USD = 6.9 yuan) and is expected to fall further in 2017 by most market participants. This reform marks an important attempt to transform the RMB’s exchange rate regime from “crawllike arrangement” to “floating regime” and even “free floating” regime. The pricing mechanism may be expressed in the following simple form5:

● Current day central parity rate=previous day closing price

s. t. ( current day’s closing price- current day’s central parity rate)/(current day’s central parity rate)≤2%

In the first two days of the “August 11 reform”, the central bank was shocked to see the RMB devaluation of almost 2% each day, hitting the lower limit. It was feared that the depreciation could spin out of control. Officials came out to say that this was a onetime adjustment of the exchange rate, and the 3% adjustment so far achieved was enough to correct the overvaluation. Thus the reform experiment was brought to an abrupt end. With hindsight, we can venture to say that if the central bank did not intervene after the three days’ trial, and waited for a week or two, the exchange rate might eventually be stabilized, and the reform of the exchange rate regime may have succeeded. The general direction of the “August 11 reform” is correct, but unfortunately the reform failed to be carried through.

In the period from August 13, 2015 to the Spring Festival in February 2016, no one was quite sure what was the rule that guided the setting of the central parity rate. What confused the market was that when the devaluation pressure was building up, against the market expectations, the RMB would appreciate rather than depreciate. The explanation for this behavior pattern was that the PBoC was manipulating the exchange rate to move in an unexpected fashion to break depreciation expectations. For many months after the August 13, despite the strong depreciation expectations, the yuan appreciated rather than depreciated.

In January 2016, a new RMB exchange rate formation mechanism was adopted, which was based on the formula of “closing price +

theoretical value of the exchange rate that will keep the index of a currency basket unchanged”. Although the central bank did not explicitly announce it, central bank officials and the market generally acknowledged the existence of such a rule. The main trust of this new mechanism can be expressed as follows6:

● Current day’s central parity rate=previous day’s central parity rate +{( previous day’s closing price- previous day’s central parity rate) + ( theoretical central parity rate to keep the basket of currencies stable over 24 hours - previous day’s central parity rate)}/ 2

Or another equivalent formula:

● Current day’s central parity rate = ( previous day’s closing price + theoretical central parity rate to keep the basket of currencies stable over 24 hours)/2

It can be seen from the formula that if taking out the factor of keeping the basket of currencies stable, we will return to the rule of “August 11 reform”. The composition and currency weights of the currency basket are published by the PBoC. The index of the currency basket that is calculated according to a published formula is the CFETS (China’s foreign exchange trade system) index7, which includes the exchange rates of 13 currencies against the RMB8 and takes the following form:

Where, 100.02 is the sum of currency weights times 100; 0.2640 is the dollar’s weight; 6.1190 is the RMB’s central parity price against the dollar in January 2014 ( price in the base period), and so on and so forth. If the RMB is pegged to CFETS index, the PBoC must adjust the RMB’s exchange rate against the dollar in case the dollar’s two- way exchange rates with other currencies change over the base period to bring CFETS index back to 100. This adjustment is achieved through the “theoretical central parity rate to keep the basket of currencies stable” (“theoretical value” for short in the following). In the previous example, when the US dollar exchange rate against the RMB changes from 100 to 140, in order to let the basket currency index remain unchanged, the RMB must depreciate against the US dollar to 6.99. Here 6.99 is the theoretical central parity rate that keeps the basket of currencies stable. Before foreign exchange market opens, market participants will already know the dollar’s twoway exchange rates with other currencies. Thus, by modifying equation (1) and making CFETS index equal to 100, we have:

Based on the above formula, we may obtain the “theoretical value” ($/¥) that keeps CFETS at 100. When the PBoC announced the rule of “closing exchange rate + exchange rate variations of a basket of currencies”, it was widely believed that “maintenance of exchange rate stability of currency basket is the keynote of the RMB’s exchange rate formation mechanism in the foreseeable future.” However, according to the PBoC’s new formula of central parity rate, current day’s central parity rate will equal to the theoretical value only when current day’s closing price equals the theoretical value, which normally will not occur. In other words, the PBoC’s pricing formula has determined that CFETS index is impossible to remain unchanged in normal situations.

Probably due to concerns that pegging to CFETS index of base period will cause excessive volatility of the central parity rate, the PBoC pegged the RMB to the CFETS index of the previous day. Even so, the closing price of the RMB against the dollar in the previous day normally will not equal to the “theoretical value” of current day. In this manner, the CFETS index of the next day will change as the central parity rate deviates from the “theoretical value”. Obviously, although the PBoC’s central parity rate in formula contains an index of a basket of currencies, it is very different from “peg

to a basket of currencies” in the conventional sense as the CFETS index to which the RMB is pegged keeps changing every day.

Normally, countries with “soft peg” face the trade- off between the stability of foreign exchange market and the stability of basket currency index (the currency’s nominal effective exchange rate stability). While attempting to make the RMB’s nominal exchange rate reflect market supply and demand, China also strives to maintain the stability of basket currency index. The former reflects change in the closing price and the latter reflects variations in the “theoretical value” over 24 hours. Such an exchange rate formation mechanism is probably unique in the world.

According to the definition of the CFETS index and with available data, anyone can calculate the central parity rate of the RMB against the dollar on the current trading day before the market is open. Probably because the central parity rate is determined according to certain rules that allow such calculation and the band is less than 2%, IMF classifies China’s such exchange- rate regime as “crawl- like arrangement.”

2. Central Parity Rate, Dollar Index and CFETS variations

After the major depreciations at the turn of 2015- 2016, the RMB began to stabilize and slowly appreciate as of January 17, 2016, which lasted till early May. Between early May and the middle of July 2016, the RMB began to depreciate against the dollar, followed by another round of stabilization and a slight appreciation during mid-July and midSeptember. After October, the RMB began to depreciate against the USD at an accelerated pace. From December 11, 2015 to December 16, 2016, the RMB depreciated against the dollar by eight percentage points.

From the end of January to the end of April, 2016, the dollar index had been depreciating by a wider margin than the RMB’s depreciation against the dollar. Afterwards, the dollar index had been mostly appreciating. From late August till now, the dollar index exhibited a strong momentum of appreciation despite occasional volatility. Between December 11, 2015 and December 16, 2016, the dollar index appreciated by 5.3 percentage points.

Meanwhile, CFETS index had been on the decrease, down 7.3 percentage points by July 8, 2016, which is two times as much as the RMB’s depreciation against the dollar. In the six months that followed, CFETS index had been rather stable. By December 11, CFETS index dropped by 6.5 percentage points over a year.

How does the RMB exchange rate against the dollar relate to CFETS index and dollar index variations?

By analyzing the configuration of the CFETS index, we can identify three components that determine the magnitude of the CFETS index9: the RMB exchange rate against the US dollar, the dollar index and index of the rest of currencies. If the RMB depreciates against the US dollar and the dollar index fall at the same time, the CFETS index will fall. If the RMB depreciates against the US dollar and the dollar index rise, the CFETS index may rise or fall, depending on the net impact of the depreciation of the RMB against the dollar and rise in the dollar index on the CFETS index.

Second, we assume that the dollar index is an exogenous variable and the path of dollar index variation is given, i. e. if the “CFETS dollar index” and other currency indexes fall when the dollar’s exchange rate against the RMB increases ( the RMB depreciates against the dollar), the CFETS index will fall.

Third, movement of the RMB exchange rate ( the central parity rate) and that of the dollar index are assumed to be independent, and change in the CEFTS index is a result of the interaction between the RMB exchange rate and the dollar index. In the discussion, it is assumed that the CEFTS index does not affect the RMB exchange rate. Obviously, this assumption is contradictory to the central parity rate formula. But the contradiction does not impede our analysis on the relationship between RMB exchange rate and the CFETS index.

As can be learned from simple mathematical analysis, when both the dollar index and the central parity rate of the RMB are falling, the CFETS index will fall. Yet when the dollar index increases and the central parity rate falls, whether the CFETS index will rise or fall depends on the relative magnitude by which the central parity rate falls. If the central parity rate falls by an enough degree, the CFETS index will fall; otherwise the CFETS index will rise. During the rise of the dollar index, if the central parity rate falls by a moderate degree, the CFETS index will remain unchanged10. However, under the rule of “closing exchange rate+ exchange rate variations of a basket of currencies”, the determination of the RMB’s central parity rate against the dollar will be affected by the theoretical value of the CFETS index to keep the basket of currencies stable over 24 hours. Will the introduction of the central parity rate- setting rule affect our conclusion on the relationship among the central parity rate, the dollar index and the CFETS index? Here, we create an equilibrium state: previous day’s closing price = the theoretical value to keep the basket of currencies stable = 6.5; CFETS index = 100. Proceeding from this equilibrium state, both the dollar index and the central parity rate will fall. If the closing price falls to 6.6, the theoretical value should increase to 6.3. According to the price- setting rule, the

current day’s central parity rate should be 6.45. Because the appreciation of current day central parity rate is insufficient ( should be 6.3), the current day’s CFETS index will be smaller than 100. Obviously, although the introduction of the price-setting formula will affect the path in the change of CFETS index, the basic direction of interaction among these variables will not change.

In the first four month in 2016 when the dollar index11was falling, to maintain the stability of the CEFTS index, the RMB should have appreciated. But facing the depreciation pressure in the market, the PBoC wishes to preserve its ammunition. Hence, it refrained from the intervention to prop up the RMB exchange rate significantly. As result, the CEFTS fell materially.

From April to the later July 2016, because the dollar index was on the rise mostly, to maintain the stability of the CEFTS index, the RMB should fall. In fact, the RMB did fall but the depreciation exceeded what was required to keep the CFETS index stable. Hence the CEFTS fell by a wider margin than it did when the dollar index fell.

Since late August 2016 the dollar index rose strongly. To maintain the stability of the CEFTS index, the RMB should fall. In fact, the PBoC allowed it to fall substantially. Because the dollar index rose substantially, the index kept stable while the central parity rate was falling (Figure 2).

Through further discussion, we may uncover the following interesting findings arising from the determination of the central parity rate under the “closing exchange rate + exchange rate variations of a basket of currencies” formula.

If the dollar index remains unchanged, the cumulative decrease of RMB’s closing price over the central parity could be substantially smaller than the sum of daily closing price decreases against the central parity. This is determined by the PBoC’s formula for determining the central parity rate:

Current day’s central parity rate ( previous day’s closing price + theoretical central parity rate to keep the basket of currencies stable over 24 hours)/2

In the above discussion, movement of the RMB exchange rate ( the central parity rate) and that of the dollar index are assumed to be independent, and change in the CEFTS index is a result of the interaction between the RMB exchange rate and the dollar index. In the discussion, it is assumed that the CEFTS index does not affect the RMB exchange rate. But according the new central parity rate setting rule, the determination of the RMB exchange rate is not independent of the dollar index, rather it is jointly determined by both the “previous day’s closing price” and the “theoretical value”. The latter in turn is determined by the dollar index as well as the previous day’s CFETS index. However, despite the restrictions imposed on the relation between the RMB exchange rate, the dollar index and the CFETS index, by the central parity rate-setting rule, the basic relation among them will not change significantly. If depreciation pressure on the RMB is building up, while the dollar index is falling, without taking into consideration the central parity ratesetting rule, we should conclude that the CFETS index would fall. But if the rule has been taken into consideration, would the result be the same?

I f the central parity rate is entirely determined by the “theoretical value”, regardless the changes in both the dollar index and the previous day’s closing price, the CFETS index will be unchanged. This is what happens in a basket- peg regime. However, because of the introduction of the central parity rate- setting rule, now the closing price is as important as the “theoretical value” in the determination of the CFETS index. When the dollar index is falling, the “theoretical value” should be rising. If yesterday’s closing price is lower than today’s “theoretical value” ( say, yesterday’s closing price is 6.7 and the “theoretical value” is 6.5), today’s central parity of the RMB will be lower than the “theoretical value”. As a result, today’s CFETS index will fall. In fact, because we have assumed that the RMB is in the process of depreciating against the dollar, today’s central parity rate must be lower than yesterday’s central parity rate, which in turn implies

that yesterday’s closing price must be lower than today’s “theoretical value”. Otherwise, today’s central parity rate cannot be lower than yesterday’s central parity rate. It shows that when both the dollar index and the central parity rate of the RMB are falling, the CFETS index will fall. In other words, with or without taking into consideration of the central parity ratesetting rule, the result is the same.

What will happen to the CFETS index, if the dollar index is on the rise, while the RMB is falling? According to the rule, in response to the rising in the dollar index, the “theoretical value” should fall. There are two possibilities with regard to the previous day’s closing price. One possibility is that the previous day’s closing price is lower than the “theoretical value”. If so, the CFETS index will fall, because the previous day’s closing price will make today’s central parity rate that determines today’s CFETS index lower than “theoretical value”. Another possibility is that the previous day’s closing price is higher than the “theoretical value”. Under this circumstance, it is possible that the CFETS index will rise, while the RMB exchange rate in the form of the central parity rate is falling. This possibility is easy to see when the dollar index rises significantly and hence the “theoretical value” falls significantly. Despite that yesterday’s closing price is higher than the “theoretical value”, as an arithmetic mean of yesterday’s closing price and the “theoretical value”, today’s central parity rate, dragged down by the low “theoretical value”, still can be lower than yesterday’s central parity rate. Hence, whether or not to take into consideration the central parity rate-setting rule will make some differences in the results of the movement of the CFETS index, but the direction should be more or less the same.

Some argue that the depreciation of the RMB since August 2016 is entirely attributable to the rise in the dollar index. This argument is questionable. Assume that there is not depreciation pressure in the market, and then the closing price should be unchanged following the passage of time. If the dollar index is rising continuously, the “theoretical value” should fall continuously while the closing price remains unchanged. Combining a constant closing price and a falling “theoretical value”, the central parity rate will fall steadily (RMB depreciation). As a result, sooner or later the unchanged closing price will hit the higher limit of the 2% band of the downward moving central parity rate. The PBoC will have to intervene in the market to purchase the dollar and sell the RMB to push up the closing price (forcing the RMB to depreciate). On the other hand, if there is depreciation pressure in the market, while the dollar index is rising continuously, the PBoC can just allow the closing price to fall (RMB depreciation) to keep pace with the falling “theoretical value” without intervention. As a result, the depreciation of the RMB will coincide with the rise in the dollar index and a constant CFETS index. This actually is what we saw since August 2016.

After the introduction of the central parity rate- setting rule, to follow through the rule, besides publishing the central parity rate daily, the PBoC has to intervene in the market constantly. Perhaps, the most important entry point for the intervention is the closing price. Today’s central parity rate is determined by yesterday’s closing price and the dollar index at the time when the market is open. But all these are history and already decided. The only thing the PBoC can do about is today’s closing price. When the PBoC reckons that more depreciation pressure should be released, it will allow the spot rate to hit the lower limit. Otherwise, it will intervene to make the closing price to be maintained at a given level. If, by chance, the dollar index rises strongly next day, the PBoC will be very happy, because while large depreciation pressure has been released, the CFETS index remains unchanged. If the dollar index stops rising or even turns to falling, while the PBoC wishes to continue to release depreciation pressure, it has to tolerate the fall in the CFETS index. If the PBoC wishes to maintain the stability of the CFETS index, it has to use foreign exchange reserves to prop up the closing price so as to arrest the fall in the central parity rate. In short, despite the complication

created by the central parity rate- setting rule, the PBoC has to use foreign exchange reserves constantly to maintain an artificial exchange rate. Despite all the complications, in essence, this regime has no fundamental difference from the regime of hard peg to the US dollar.

3. Successes and Flaws of New Exchange Rate Formation Mechanism

It is clear that the central parity rate-setting rule makes it impossible for the RMB to peg to a basket of currencies. What is the purpose of introducing such a central parity rate-setting rule? Our guess is that the PBoC wishes that this mechanism could help to stabilize the RMB exchange rate while releasing the depreciation pressure gradually.

With the same amount of depreciation pressure, the new rule can slow down the pace of devaluation. For example, according to the rule introduced during the “August 11 reform”, if the central parity rate depreciated by 2% per day, for 10 days it would depreciate by 20%. But according to the new rule, if the central parity rate depreciated by 2% per day, the accumulated depreciation in 10 days could be zero or other figures. Why? If today’s closing price hits the lower limit of the floating band and is 2% below today’s central parity, the central parity tomorrow still can be the same as today’s central parity. The reason is that the determination of tomorrow’s central parity will take into account changes in the dollar index. If the dollar index falls over the past 24 hours, the rise of the theoretical exchange rate may well offset the impact of the fall in yesterday’s closing price on the determination of today’s central parity.

Compared with the “opening price (central parity rate) determined by previous day’s closing price” under the “August 11 reform”, “closing exchange rate + exchange rate variations of a basket of currencies” mainly have the following differences: first, with other conditions being equal, the RMB’s depreciation against the dollar slowed; second, due to the unpredictability of the dollar index and the movements of other currencies, it is more difficult for market participants to forecast RMB’s exchange rate movements. Probably due to the increased uncertainty of exchange rate movements, market expectations on exchange rates diverged and speculation on the RMB’s fall against the dollar reduced. As in the words of the PBoC, “due to uncertain dollar trends, the reference to a basket of currencies will also bring about two- way float of the RMB against the dollar, which helps break the one- way expectation and curb oneway speculation.” Nevertheless, the flaws of the new exchange rate formation mechanism are apparent as well.

The first flaw is that the two- way float is artificial, not market- driven, so it cannot be sustained. To keep the RMB exchange rate at an artificially higher level than the market can support, foreign exchange reserves have to be spent continuously.

Now, let us examine the three scenarios where RMB depreciation pressures coexist with rising dollar index:

(1) Closing price is equal to the theoretical value and both of them are set to be 6.5. According to the central parity rate- setting rule, current day’s central parity rate is 6.5. If the closing price is in the range of 6.5±2%, the PBoC does not need to intervene in the foreign exchange market, i. e. the situation during the “August 11 reform” period: current day’s central parity price = previous day’s closing price. If the central bank does not intervene, the current day’s closing price may fall by 2% on the various pressures including depreciation expectations.

( 2) Previous day’s closing price is higher than the theoretical value and the former is set to be 6.7 while the latter is 6.5. According to the “reference closing price” rule, current day’s central parity rate is 6.7 and the PBoC must ensure that the closing price is in the range of 6.7± 2%. According to the new rule, current day’s central parity rate should be 6.6 and the PBoC must ensure that the closing price is in the range of 6.6±2%. Thus, compared with the old rule, the PBoC is more likely to intervene in the foreign exchange market by raising the RMB’s exchange rate against the dollar under the new

rule provided that the depreciation pressures are the same.

( 3) Previous day’s closing price is lower than the theoretical value and the former is set to be 6.5 while the latter is 6.7. According to the “reference closing price” rule, current day’s central parity rate is 6.5; following the new rule, current day’s central parity rate is 6.6%. Compared with the old rule, more depreciation pressures will be released under the new rule and the closing price would be lower ( wider depreciation) provided that the depreciation pressures are the same.

We may proceed to examine the two possible situations where RMB depreciation pressures coexist with falling dollar index.

(4) Closing price is equal to the theoretical value and both of them are set to be 6.5. According to the central parity rate- setting rule, current day’s central parity rate should be 6.5. As the dollar index is falling, market participants will expect the central parity rate to rise on the next day and thus cause the floating band to move upwards. Under this expectation, depreciation pressures may subside for some time. In this situation, the PBoC may not need to intervene in the foreign exchange market.

(5) Closing price is not equal to the theoretical value with the former set to be 6.7 and the latter 6.5. According to the “reference closing price” rule, current day’s central parity rate should be 6.7; under the new rule, current day’s central parity rate should be 6.6. Under the depreciation pressure, if the PBoC does not intervene in the market, the closing price may plunge regardless of the central parity rate. To keep the RMB’s exchange rate stable around the new parity rate, the PBoC must conduct reverse operations to curb the RMB’s depreciation or induce appreciation. However, such an operation requires consumption and sometimes significance consumption of foreign reserves.

As can be seen from the above five scenarios, unless a certain unlikely event occurs, i. e. Scenarios ( 1) and ( 4) where closing price = theoretical value, the PBoC’s intervention in foreign exchange market is inevitable if the central parity rate-setting rule is executed, while Scenarios (2) and (5) entail the consumption or significant consumption of foreign exchange reserves. Scenario ( 3) corresponds to a wider depreciation of the RMB that may intensify depreciation expectations.

In the recent round of the RMB’s depreciation, a popular view is that the RMB is not depreciating and the problem lies in the dollar’s appreciation. According to this view, even if the RMB’s depreciation pressures do not exist in the foreign exchange market, the RMB will still depreciate against the dollar with the requirement to keep the CFETS index stable. This assessment would be correct if China had adopted an exchange rate system that pegs to a basket of currencies. However, as mentioned before, the problem is that China’s exchange rate system is not a real peg to a basket of currencies. The RMB’s exchange rate against the dollar is not only subject to the need to keep the basket of currencies stable but also subject to the relative supply and demand of the RMB versus the dollar.

If the RMB’s depreciation pressures against the dollar do not exist, when the dollar index is rising and the theoretical value is falling, the closing price ( spot exchange rate upon closing) should be maintained at a given level. As the falling central parity rate increasingly deviates from the constant closing price, the PBoC will be forced to buy the US dollar and sell the RMB to let the closing price fall in order to stay in the range of ±2% of the central parity rate. But this situation never occurred. Therefore, the argument that “RMB is under no depreciation pressures against the dollar and the falling central parity rate and closing price are totally caused by the rising dollar index” not only contradicts with the reality but is theoretically questionable as well. In fact, the rising dollar index only accelerated the release of the RMB’s depreciation pressures against the dollar. Some market participants argued that more consideration should be given to the closing price in determining the central parity rate. This proposal is not unjustified. In fact, it is a proposal to return to the pricing method of “reference closing price.”

In a word, the pre-requisite for the PBoC to follow the current central parity rate-setting rule is sufficient foreign exchange reserves. In less than two years, China consumed more than 800 billion US dollars for the maintenance of RMB’s exchange rate stability. After the Spring Festival of 2016, the falling dollar index and increased capital control slowed foreign exchange reserves depletion. However, with the rise of the dollar index and increasing capital outflows over the past few months, the depletion of foreign exchange reserves picked up speed once again. Long- lasting interventions caused continuous depletion of foreign exchange reserves. Once the level of foreign exchange reserves falls below a certain psychological threshold, the capital outflows and capital flight will surge. After the depletion of massive foreign exchange reserves, the substantial depreciation of RMB’s exchange rate is still unlikely to be averted.

Second, current exchange rate formation mechanism may neither reverse nor eliminate the RMB’s depreciation expectation. Since the PBoC’s announcement of the CFETS index in December 2015, the RMB’s closing price against the dollar was below the average opening price only in February and July 2016. The closing price was above opening price in all other months (direct quotation method, with increase denoting depreciation). This suggests that the RMB’s depreciation pressures always existed in the market then. In October 2016, the RMB’s closing price dropped by 40 basis points on a daily average basis under the strong dollar index, reaching the highest level since the “August 11 reform”. In the foreseeable future, the RMB’s depreciation pressures are likely to escalate.

There are signs that even though the RMB’s depreciation pressures lessened at times, such pressures still persist. This can be evidenced by the forward settlement contracts continuously

outnumbered by forward sale contracts. When the RMB’s appreciation expectation holds sway, firms will sign forward settlement contracts with banks, locking up the amount of conversion from the dollar into the RMB to avoid losses from the dollar’s depreciation. At the same time, there were fewer forward sale contracts. After the “August 11 reform”, the RMB’s depreciation expectation surged, prompting a large number of exporters to sign forward sale contracts with banks, locking up the cost to buy the dollar ahead of time. In September 2015, the PBoC announced the requirement of 20% deposit margin for forward sale contracts, which raised the cost for firms to avoid exchange rate risks using forward contracts. Although the numbers of forward settlement contracts and forward sale contracts all plummeted, forward sale contracts still outnumbered forward settlement contracts and the difference tends to rise. Expectation for the RMB’s one-way depreciation still exists in the forward market.

In the derivatives market, the RMB’s short sellers are waiting for their chance. This can be evidenced in the relative change of realized volatility and implied volatility. The realized volatility captures the previous actual volatility in the foreign exchange market and the implied volatility calculated in options is a forecast of future volatility. The following chart shows that prior to the “August 11 reform”, the implied volatility was more or less equivalent to or even smaller than the realized volatility. This suggests that back then, the market believed that the RMB’s exchange rate would be more stable than before. After the exchange rate reform, however, the implied volatility began to surge and its difference with the realized volatility peaked at 6.7 and the shorting sentiment on the RMB peaked as well. Even after the RMB’s realized volatility recently stabilized, the implied volatility is still higher than realized volatility by around 2.5. This indicates the existence of many potential short sellers waiting for the opportunity to short the RMB.

Under the existence of speculation pressure as a future trend, will the current pricing mechanism do more to eliminate the depreciation expectation than does a fixed exchange rate regime? The answer also seems to be negative.

Third, another important flaw of “closing price + stability of currency basket over 24 hours” is that it compromised the independence of monetary policy. As noted in the PBoC’s Monetary Policy Report Q2, 2016, “if

the reserve requirement is to be lowered continuously, the released liquidity will push down market interest rates ... ... leading to increase in RMB depreciation pressure and further depletion in foreign exchange reserves. The more liquidity is released, the stronger the depreciation expectations become, and the more likely that speculators will use the money to buy foreign currency, thus establishing a cycle”. The message is that even if the new exchange rate formation mechanism is adopted, concerns for depreciation have still seriously affected the independence of the PBoC’s monetary policy.

Theoretically, “closing price + a basket of currencies” is a hybrid of two exchange rate formation mechanisms. One references the floating exchange rate of closing price, which is generally consistent with the direction of market supply and demand and reflects domestic economic fundamentals; the other references a basket of currencies which is consistent with the direction of the relative price volatility of other currencies and mainly reflects changes in overseas economic situation.

Both mechanisms have their merits. However, their combination is problematic. Based on the closing price, the RMB’s exchange rate against the dollar is determined by economic fundamentals, i.e. the RMB will become strong when domestic economic indicators take an upswing and vice versa. Yet the theoretical value for the stability of currency basket is determined by the relative trends of other currencies. When the US economy is stronger than the European and Japanese economies, the RMB will depreciate against the dollar irrespective of China’s domestic economic fundamentals; on the contrary, the RMB will appreciate against the US dollar. The two mechanisms may offset or reinforce each other under different shocks, which may cause the RMB’s exchange rate to deviate from economic fundamentals. This may suggest that the PBoC needs to implement a monetary policy that departs from economic

fundamentals.

Fourth, in guiding the RMB’s slow depreciation, the PBoC significantly increased capital control to reduce the depletion of foreign exchange reserves and maintain the independence of monetary policy as much as possible. Given the current situation, capital controls must be enhanced rather than weakened. However, the side effects of capital control are also significant. For instance, it led to shrinking foreign exchange market transactions, which is unfavorable to China’s trade and investment activities. While capital control curbed speculation through long- term sale contracts, it also depressed the forward market as a whole, slashing forward contracts after the “August 11 reform” and increasing the cost of risk avoidance for firms. Increased capital control will inevitably impeded the RMB’s internationalization process. In addition, it will also give rise to various illegal activities to bypass regulation and the rising cost of regulation. Exchange rate fluctuations may serve as a buffer of external shocks. Free float of exchange rate will greatly lessen the burden of capital control and pave the way for the ultimate abolishment of capital control, the realization of RMB convertibility under capital account and capital account liberalization.

4. Policy Options

Needless to say, significant RMB depreciation pressure exists in the current foreign exchange market. As US President Donald Trump took office, this pressure is likely to grow. In the face of depreciation pressure, the PBoC has the following three options: First option, to stop intervention in the foreign exchange market, and release the devaluation pressure in a one-off move; second option, peg to the dollar and declare that there will be absolutely no devaluation while strengthening capital controls; third option, to guide the gradual depreciation of the exchange rate through some measures in hoping that the depreciation pressure will gradually disappear.

The second method was employed in 1998, and had been successful. Can this be done now? We have announced that the RMB will remain relatively stable around a reasonable and equilibrium level; that is not absolute stable; the exchange rate has depreciated over 5% this year, and now people all expect the RMB will depreciate further. It is almost impossible to make people to believe that the RMB will not depreciate any further. Furthermore, China now is too open to implement capital controls as strictly as in 1998.

The PBoC currently follows the third method, i. e. to guide the gradual depreciation of the exchange rate through some measures in hoping that the depreciation pressure will gradually disappear. However, the problem with this method is that depreciation pressure cannot be released at one go. Since the PBoC’s announcement of the CFETS index, the closing price was below the average opening price only in February and July 2016 and was above the opening price in all other months ( direct quotation method where increase denotes depreciation). The implication is that RMB depreciation pressure always existed in the market and depreciation expectation never disappeared. In October 2016, RMB’s closing price dropped by 40 basis points on a daily average basis, reaching the highest level since the implementation of “closing price + a basket of currencies” mechanism.

A popular view attributes RMB depreciation to the depreciation expectation. However, the expectation is not unwarranted. In fact, the RMB expectation followed rather than preceded the deterioration in China’s international balance of payments. Exchange rate policy should not aim to manipulate expectation, still less should it manipulate the magnitude and pace of RMB depreciation to curb depreciation expectation. First, the expectation of RMB depreciation is not the only reason that led to depreciation and cannot be addressed without eliminating the underlying factors. Second, expectation itself is also hierarchical. For instance, the expectation of China’s economic growth and reform prospects will also affect RMB expectation. Obviously, maintaining exchange rate stability alone does

little to address macroeconomic expectations. The only way to eliminate RMB’s depreciation expectation is to phase out intervention and let the market decide exchange rate. Intervention may limit volatility but cannot reverse the trend. If depreciation is an irresistible trend, it will not automatically reverse in a short period of time. Persistent one-way intervention is just a waste of resources and ultimately has to be abandoned.

We advocate that foreign exchange market interventions be phased out as soon as possible to let the RMB to float freely. Under the floating exchange rate regime, deterioration in the international balance of payments will be immediately reflected in the depreciation of exchange rate, which in turn will lead to a swift upturn in international balance of payments, thus preventing the accumulation of depreciation pressures. This is the real significance of “two- way volatility.” Delaying the release of depreciation pressures will only increase the repercussions and destructiveness once the pentup pressures burst.

Of course, given the uniqueness of exchange rate, we cannot preclude the possibility of continuous exchange rate depreciation and over- adjustment. For this reason, we strongly support the PBoC’s adjustment of capital control policy. On the other hand, RMB depreciation is not as dire as many would think. According to international literature, if the currency depreciates by over 25%, four problems will occur: inflation, currency mismatch on bank balance sheets, sovereign debt crisis, and corporate debt crisis. In China, only the fourth problem is cause for concern. Under the RMB’s appreciation expectation in the past, Chinese firms borrowed large sums of foreign debts. Once the RMB depreciates, corporate debts in terms of RMB are likely to surge. Nevertheless, China’s corporate foreign debts have significantly reduced and the share of foreign debts in total corporate liabilities is limited. Therefore, Chinese enterprises should be able to withstand the repercussions of significant RMB depreciations.

Another important feature of China’s economy is the outsize share of M2 in GDP. Many people are worried that once the RMB is allowed to depreciate, more people will change the yuan into the dollar, causing the RMB to depreciate further. The outsize share of M2 in GDP is indeed a cause for concern and justifies opposition to the premature opening of capital account. But it cannot be used as an excuse to oppose exchange rate liberalization. Without capital control, foreign exchange reserves will be quickly depleted to maintain exchange rate in the event of capital flight. The problem here is the timing of capital account liberalization rather than the choice of exchange rate regime. Indeed, exchange rate cannot be truly market- based when capital control is retained. Nevertheless, this transition is inevitable for China’s exchange rate liberalization process. With capital control, depreciation will not spin out of control once RMB exchange rate is liberalized. On the contrary, exchange rate depreciation will lower the dollar price of RMB-denominated assets by raising the RMB price of dollar- denominated assets. This self- regulatory function will improve international balance of payments, reduce capital control pressure and mitigate the distortions of market price and resource allocation caused by capital control.

There is a popular view that once confidence is shaken, the RMB will start its freefall. But never in the world economic history has this situation occurred: for a country with the largest trade surplus in the world, outstripping the rest of the world in terms of economic growth rate, boasting the largest foreign exchange reserves in the world and returning a financial assets far above that of the US, how can its currency depreciate by 20% to 25%? China’s economic fundamentals do not support any significant depreciation of the RMB. Any overadjustment of RMB exchange rate will be a blip phenomenon and will finally return to the level determined by the fundamentals, not to mention the fact that China still has capital control as the last defense. Hence, short- term swings are not cause for concern. As mentioned at the beginning of this paper, among the 191 IMF member countries, only China and 19 other countries have adopted a “crawl- like

arrangement” of exchange rate regime12, almost all OECD countries and major developing countries (including India, Brazil, South Africa and Southeast Asian countries) have all adopted floating or free-floating exchange rate regimes. Compared with these countries, China should be the least afraid of depreciation and we see no reason why China cannot adopt a floating exchange rate regime as most other countries do.

Without doubt, the side effects of capital control are significant and tightening capital control is the last resort. Exchange rate volatility largely offsets the repercussions of capital flow. Had the RMB been allowed to float a few years ago, China would be in a much better position today to withstand cross- border capital flow, making capital control less necessary. Given the current situation, allowing the RMB to float will still significantly mitigate capital control pressures.

5. Concluding Remarks

After the new exchange rate regime was unveiled in February 2016, both RMB exchange rate and its expectation stabilized and foreign exchange reserve depletion slowed remarkably. Yet the turnaround of China’s foreign exchange market owes more to the PBoC’s tightening of capital control and dampened expectation of interest rate hike by the US Fed Reserve. In fact, most emerging market currencies experienced a similar turnaround after January 2016.

Given China’s hefty foreign exchange reserves, the PBoC is well-positioned to manage RMB exchange rate. While the PBoC followed opaque rules in managing exchange rate before and shortly after the “August 11 reform”, the transparency has indeed increased after the new pricing mechanism was introduced. Yet the PBoC did not change its practice of maintaining exchange- rate stability through intervention. Introducing the basket of currencies has increased the uncertainty of central parity rate. However, this new pricing mechanism cannot clear the market nor curb the accumulation of depreciation pressures.

In the foreseeable future, the reallocation of dollar assets triggered by steeper return to dollar assets will cause the dollar index to rise and induce capital outflows from developing countries, which inevitably exert greater depreciation pressures on the RMB. Capital control is not the panacea for maintaining financial stability and the cost of capital control will keep rising. If the government aims to keep exchange rates stable and curb the depletion of foreign exchange reserves, the only option at its disposal is to tighten capital control. However, given China’s long course of capital account liberalization, backpedaling is difficult and costly. Since the losses are inevitable, what we can do is to minimize the consequences. What China faces is the impossible trinity to keep exchange rates stable, maintain foreign exchange reserves and protect national credibility. For example, free remittance of profits by foreign businesses is a commitment that China made decades ago and has honored ever since. Any obstruction of the repatriation of profits because of the fear of foreign exchange reserve depletion is a breach of promise, which is extremely harmful and damaging to the credit of a country. The credit of a nation is more precious than foreign exchange reserves. To reduce the burden of capital controls, China should let go the exchange rate. Despite the risks, this is not the worst option. We hope that the authorities can make up their minds early, and take the opportunity now before the Trump administration takes any relative actions.

Figure 1: Volatility of RMB’s Spot Exchange Rate against USD against Central Parity

Source: Wind database.

Figure 2: RMB’s CFETS Index and the Dollar Index

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