Forg­ing a new cur­rency or­der

The Pak Banker - - OPINION - Av­inash Per­saud

THE pace of de­cline in China's ex­ter­nal cur­rency re­serves is ac­cel­er­at­ing, feed­ing pan­icky sell­ing of the yuan and herald­ing a likely change in China's ex­change rate ar­range­ments. Ex­change rate pres­sures in China are spilling over on to re­gional cur­ren­cies and global stock mar­kets. In Jan­uary alone, China lost $99.5 bil­lion of its dol­lar re­serves, try­ing to keep the yuan in its 2% of­fi­cial fluc­tu­a­tion band around 6.5419 to the dol­lar.

In just 15 months, the Chi­nese have lost in ex­cess of $650 bil­lion of re­serves, more than the to­tal re­serves of any other coun­try save Ja­pan. In be­tween mas­sive in­ter­ven­tions, the Chi­nese govern­ment has tried to stem pres­sure through small de­val­u­a­tions and in­creas­ing the costs for those go­ing short on the yuan. This isn't just an­other emerg­ing mar­ket cur­rency cri­sis. China is the se­cond largest econ­omy and its re­sponse to this fire could forge the be­gin­nings of a new cur­rency or­der.

The mar­ket un­rest has puz­zled many. China's re­serves are still over $3 tril­lion and they dwarf short-term ex­ter­nal debt, which is ap­prox­i­mately $625 bil­lion. The slow­down in the Chi­nese econ­omy was well flagged. I sus­pect the shattering of the mar­ket's pre­vi­ous con­fi­dence that the Chi­nese govern­ment was om­nipo­tent in mat­ters such as ex­change rates has played an in­tan­gi­ble but pow­er­ful role in the de­scent to risk aver­sion by Chi­nese cor­po­rates and res­i­dents.

In the first two decades of my work­ing life, I made a de­cent liv­ing in for­eign ex­change deal­ing rooms. My ex­pe­ri­ence is that in th­ese risk-averse en­vi­ron­ments, sell­ing is not con­fined to the nor­mal met­rics of po­ten­tial cur­rency pres­sure such as short­term ex­ter­nal debt or wors­en­ing trade po­si­tions. The sell­ing spreads to lo­cal cor­po­rates and res­i­dents and they only have to try to switch a small part of their stock of do­mes­tic as­sets into for­eign cur­rency for any level of re­serves to be over­whelmed.

Sell­ing pres­sure from lo­cals is of­ten in­suf­fi­ciently con­sid­ered, es­pe­cially as they are adept at find­ing ways to sell lo­cal cur­rency be­neath of­fi­cial scru­tiny. I re­call Ber­tie Ah­ern, then Ir­ish fi­nance min­is­ter, ex­cit­edly threat­en­ing to name and shame US hedge funds that had sold the punt ahead of the Fe­bru­ary 1993 de­val­u­a­tion. Later, tucked away in the back pages of the Ir­ish Times, I saw a list of sellers that was dom­i­nated by lo­cal cor­po­rates.

Rightly or wrongly, I sus­pect Chi­nese of­fi­cials will be per­suaded that the only way to al­le­vi­ate the pres­sure on ex­ter­nal re­serves and hence do­mes­tic liq­uid­ity is to change the ex­change rate regime. The ob­jec­tive of any change will be to re-es­tab­lish "two-way" mar­kets of buy­ers and sellers. Of­fi­cials are, there­fore, likely to be fu­ri­ously de­bat­ing stick­ing to nar­row bands but de­valu­ing to a su­per-com­pet­i­tive rate, or switch­ing to a free float or some­thing in be­tween.

Nar­row bands in­vite spec­u­la­tion. When an ex­change rate is on the weak side, the cen­tral bank buys lo­cal cur­rency from the spec­u­la­tor more ex­pen­sively than any­one else, and if the spec­u­la­tion fails to lower the lo­cal cur­rency through the band, it lim­its the spec­u­la­tors' loss by of­fer­ing to sell the cur­rency at the other side of the nar­row band. But pol­i­cy­mak­ers in highly open economies have a wellde­vel­oped fear of float­ing. They ob­serve wild swings in sen­ti­ment and be­lieve large ex­change rate shifts eas­ily be­come self-ful­fill­ing prophe­cies: de­pre­ci­a­tion begets in­fla­tion, which begets de­pre­ci­a­tion. In the cur­rent fren­zied sit­u­a­tion, a free float could eas­ily lead to the yuan crash­ing through 8.50 ver­sus the dol­lar. That could turn a cur­rency cri­sis into a political and trade cri­sis be­fore the cur­rency has a chance to bounce.

In my ex­pe­ri­ence, the holy grail of for­eign ex­change rate ar­range­ments is one that of­fers both guid­ance to the mar­ket and flex­i­bil­ity like John Wil­liamson's idea of tar­get zones. The clos­est thing I have seen to this in real life was the pe­riod of +/-15% fluc­tu­a­tion bands within the Euro­pean Ex­change Rate Mech­a­nism (ERM) from 1993 to 1999. In the early years, when the sys­tem was not sup­ported by ex­pec­ta­tions that Eco­nomic and Mon­e­tary Union (EMU) would ar­rive, it gen­er­ally re­duced cur­rency spec­u­la­tion.

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