Forging a new currency order
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.