The three op­tions for RMB pol­icy

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

In the three weeks since its abrupt -3% de­val­u­a­tion, the ren­minbi has re­verted to a re­mark­ably nar­row trad­ing range against the US dol­lar. How­ever, this re­dis­cov­ered sta­bil­ity does not re­flect any mar­ket belief that the ren­minbi is now ap­pro­pri­ately val­ued fol­low­ing its mod­est fall.

On the con­trary, it is the re­sult of heavy in­ter­ven­tion by the Peo­ple’s Bank of China to keep the on­shore spot rate steady at around CNY6.4 to the US dol­lar. In the near term, this fits with pol­i­cy­mak­ers’ as­ser­tions that China’s ex­change rate ad­just­ment is com­plete (last week Premier Li Ke­qiang re­it­er­ated this stance, telling a del­e­ga­tion from Kaza­khstan that the ren­minbi will not see “sus­tained de­pre­ci­a­tion”).

In the longer run how­ever, re­peated in­ter­ven­tion to main­tain the cur­rency’s sta­bil­ity is at odds with the “more flex­i­ble ex­change rate mech­a­nism” the cen­tral bank an­nounced just three weeks ago. This con­tra­dic­tion casts doubt over the PBOC’ s in­ten­tions: whether it is se­ri­ous about mov­ing to a more flex­i­ble cur­rency regime, or whether it has sim­ply re-im­posed a de facto peg at a dif­fer­ent level against the US dol­lar. As we see it, the cen­tral bank has three op­tions:

1. Con­tin­ued in­ter­ven­tion to main­tain ex­change rate sta­bil­ity.

The ob­jec­tive of this strat­egy would be to re­duce mar­ket ex­pec­ta­tions for fur­ther dep­re­ca­tion, as par­tic­i­pants bet­ting on fur­ther ren­minbi weak­ness ca­pit­u­late in the face of the PBOC’s su­pe­rior fire­power. If suc­cess­ful, the PBOC could scale back its in­ter­ven­tions, al­low­ing the ren­minbi more lee­way to float freely. The risk for the PBOC would be if its in­ter­ven­tions fail to over­come de­pre­ci­a­tion ex­pec­ta­tions. In that case, it would have achieved lit­tle or noth­ing by last month’s move, which would nei­ther have ad­vanced ex­change rate re­form, nor in­tro­duced the greater de­gree of volatil­ity the In­ter­na­tional Mon­e­tary Fund is de­mand­ing as a con­di­tion for the ren­minbi’s in­clu­sion in the Spe­cial Draw­ing Rights bas­ket. What’s more, fail­ure would be ex­pen­sive. With China’s cap­i­tal ac­count more open than in the past, and the cen­tral bank eas­ing pol­icy at home, in­ter­ven­tion to main­tain ex­change rate sta­bil­ity is get­ting in­creas­ingly costly.

As daily turnover in the on­shore spot mar­ket has shot up from US$15 bln to US$50 bln over the last few weeks, traders es­ti­mate that the PBOC and its agents have spent be­tween US$100 and US$150 bln of China’s for­eign re­serves to main­tain the ren­minbi’s ex­change rate. Of course, with US$3.7 trln in re­serves, in the­ory the cen­tral bank can go on in­ter­ven­ing for years to come. How­ever, pol­i­cy­mak­ers will gain lit­tle by run­ning down China’s re­serves at a pace of US$150 bln a month. As a re­sult, while the PBOC may adopt a strat­egy of con­tin­ued in­ter­ven­tion in the near term, say through Pres­i­dent Xi Jin­ping’s visit to the United States later this month, it is not a vi­able course of ac­tion over the long term.

3. Scale de­pre­ci­a­tion.

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2. Cease in­ter­ven­tion and size­able de­val­u­a­tion.

in­ter­ven­tion

and

al­low

a

al­low a

A large one-off move could have the merit of cur­tail­ing ex­pec­ta­tions for fur­ther de­pre­ci­a­tion. Fol­low­ing a -10% or -15% fall, sig­nif­i­cant ren­minbi buy­ing in­ter­est would emerge, avoid­ing the feed­back loop of cap­i­tal out­flows that would ac­com­pany a grad­ual de­pre­ci­a­tion. How­ever, the costs en­tailed by such a strat­egy would be con­sid­er­able. China’s lead­ers have re­peat­edly re­jected the no­tion of com­pet­i­tive de­val­u­a­tion, so a large one­off de­pre­ci­a­tion would be a diplo­matic dis­as­ter, wreck­ing Bei­jing’s cur­rency cred­i­bil­ity.

More­over, a big one-off de­val­u­a­tion would in­flict se­vere dam­age on the bal­ance sheets of those Chi­nese com­pa­nies, in­clud­ing many state-owned en­ter­prises, which have bor­rowed in US dol­lars with­out hedg­ing their ex­change rate risk.

grad­ual

Chi­nese pol­i­cy­mak­ers pre­fer to move grad­u­ally when­ever pos­si­ble. Both in­ter­est rate lib­er­al­i­sa­tion and cap­i­tal ac­count open­ing were pur­sued one step at a time, and when the con­sen­sus ar­gued that the ren­minbi was deeply un­der­val­ued, the cen­tral bank only al­lowed a grad­ual ap­pre­ci­a­tion. A grad­ual de­pre­ci­a­tion now would avoid in­flict­ing a ma­jor shock on the econ­omy, and so would be po­lit­i­cally ac­cept­able. How­ever, there would be risks. A slow and pro­tracted slide in the cur­rency could heighten ex­pec­ta­tions for fur­ther de­pre­ci­a­tion to come, so fuelling self-re­in­forc­ing cap­i­tal out­flows—the op­po­site of the in­flows at­tracted by the ren­minbi’s long years of slow ap­pre­ci­a­tion.

Each strat­egy has risks. The cur­rent “peg and in­ter­vene” ap­proach can work for a month or two, but can only be a stop-gap pol­icy. The best out­come for the PBOC would be if its in­ter­ven­tions al­layed de­pre­ci­a­tion ex­pec­ta­tions and ren­minbi buy­ers re-emerged. How­ever, that looks far­fetched. Of the other two op­tions, a grad­ual de­pre­ci­a­tion looks more likely than a one-off de­val­u­a­tion, not be­cause of its eco­nomic mer­its, but be­cause it is po­lit­i­cally more ac­cept­able and be­cause ex­pe­ri­ence ar­gues for a grad­u­al­ist ap­proach. The risk is that it will just re­in­force de­pre­ci­a­tion ex­pec­ta­tions.

What the PBOC re­ally needs at this point is a weaker US dol­lar, but that of course, is be­yond the reach of its pol­i­cy­mak­ing.

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