Right pol­icy can help tide over tough year

The Pak Banker - - OPINION - Yu Yongding

THE Peo­ple's Bank of China faces a dilemma. Af­ter nearly a decade of try­ing to curb ex­pec­ta­tions of con­tin­ued cur­rency ap­pre­ci­a­tion (spurred by China's cur­rent- and cap­i­tal-ac­count sur­pluses), it fi­nally suc­ceeded in the first quar­ter of 2014, when its force­ful mar­ket in­ter­ven­tion drove down the ren­minbi's ex­change rate to dis­cour­age carry trades. Now, how­ever, the PBoC is fac­ing an even more dif­fi­cult chal­lenge, as seem­ingly ir­re­versible de­pre­ci­a­tion ex­pec­ta­tions un­der­mine eco­nomic sta­bil­ity at a time when China can least af­ford ad­di­tional un­cer­tainty.

Be­cause the 2014 in­ter­ven­tion co­in­cided with the weak­en­ing of China's eco­nomic fun­da­men­tals, it ul­ti­mately amounted to push­ing on an open­ing door. In­stead of pro­vid­ing cred­i­ble re­sis­tance to up­ward pres­sure on the ex­change rate, as in­tended, it trig­gered an out­right re­ver­sal, with de­pre­ci­a­tion ex­pec­ta­tions be­gin­ning to creep into for­eign ex­change mar­kets. Thus, in the se­cond quar­ter of 2014, China recorded a cap­i­tal ac­count deficit for the first time in decades. And by the first quar­ter of 2015, that deficit more than off­set the cur­rent ac­count sur­plus, mean­ing that China reg­is­tered its first in­ter­na­tional bal­ance-of­pay­ments deficit in re­cent mem­ory.

None­the­less, given the size of China's for­eign ex­change re­serves, mar­kets re­mained con­fi­dent that the PBoC could fix the ren­minbi ex­change rate at what­ever level it wanted, tral par­ity rate by 1.9 per­cent, per­haps in re­sponse to an In­ter­na­tional Mon­e­tary Fund re­port en­cour­ag­ing China to align the par­ity rate more closely with the mar­ket rate. The move roiled mar­kets and in­ten­si­fied de­pre­ci­a­tion ex­pec­ta­tions. The PBoC quickly in­ter­vened to avert a panic by halt­ing the de­pre­ci­a­tion, but it was too late: ex­pec­ta­tions of the ren­minbi weak­en­ing fur­ther be­came firmly es­tab­lished in the mar­ket.

Since such ex­pec­ta­tions drive an in­creas­ing amount of cap­i­tal out of China, thereby in­ten­si­fy­ing de­pre­ci­a­tion pres­sure, the PBoC con­tin­ues to in­ter­vene in the for­eign ex­change mar­ket, of­ten in un­pre­dictable ways (in or­der to dis­cour­age spec­u­la­tion). As a re­sult, the PBoC has de facto adopted a crawl­ing-peg ex­change-rate regime. All of this has forced the PBoC to spend a huge amount of the coun­try's for­eign ex­change re­serves?more than $500 bil­lion in 2015 alone?to keep the level of ren­minbi de­pre­ci­a­tion vis-a-vis the US dol­lar within 5 per­cent. At this rate, those hard­earned for­eign ex­change re­serves will soon be ex­hausted. That is not an op­tion.

Rec­og­niz­ing the chal­lenge at hand, the PBoC has been al­low­ing the ren­minbi to fall, slowly but surely, since Novem­ber. But while this "stealth de­val­u­a­tion" worked for a while, mar­ket par­tic­i­pants de­cided at the be­gin­ning of this year to dump their ren­minbi again.

The PBoC now has three op­tions: it can stop all in­ter­ven­tions and let the ren­minbi float; link it to a bas­ket of cur­ren­cies; or peg it tightly to the US dol­lar, as it did dur­ing the Asian fi­nan­cial cri­sis of 1997. So far, how­ever, the PBoC has of­fered no in­di­ca­tion of its plans, be­yond the con­tin­u­a­tion of its cur­rent ren­minbi-sus­tain­ing pol­icy.

In my opin­ion, the PBoC should re­in­force the Chi­nese govern­ment's mar­ket-ori­ented re­form plans and al­low the ren­minbi to float. China is still run­ning a large cur­rent ac­count sur­plus and a long-term cap­i­tal-ac­count sur­plus, and it has not fully lib­er­al­ized its cap­i­tal ac­count. So the chances are good that the ren­minbi would not fall too far or for too long. More­over, even if the ren­minbi did ex­pe­ri­ence a dou­ble-digit de­pre­ci­a­tion, China would not be thrust into fi­nan­cial cri­sis. Af­ter all, the coun­try's stock of cor­po­rate ex­ter­nal debt is not too large; the cur­rency mis­match within Chi­nese banks is small; and in­fla­tion is just above 1 per­cent. To bol­ster such fi­nan­cial buf­fers, China must en­force ex­ist­ing cap­i­tal con­trols much more strictly. None­the­less, there re­mains the pos­si­bil­ity of mar­ket panic, with all of the un­cer­tainty that such an episode im­plies. Given this, the PBoC could en­gi­neer a tran­si­tion dur­ing which the ren­minbi is pegged to a bas­ket of cur­ren­cies, with an ad­justable cen­tral par­ity rate and a wide fluc­tu­a­tion band of 7.5 per­cent or even 15 per­cent.

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