China’s Dilemma: Stabilize Monetary Policy or the Renminbi?
Since 2016 began, the prospect of a major devaluation of China’s renminbi (RMB) has been hanging over global markets like the Sword of Damocles. This explains why China’s policymakers worked hard to dispel worries about the weakening RMB at the G-20 Finance Ministers and Central Bank Governors Meeting held in Shanghai on 26–27 February.
Zhou Xiaochuan, governor of the People’s Bank of China (PBOC), reiterated that there is no basis for persistent depreciation, that China will not engage in competitive currency devaluation, and that structural reforms will be implemented decisively.
However, this is not enough to persuade investors. On the first trading day since the G-20 summit, the RMB exchange rate fell 0.1% against the US dollar, its fifth consecutive day of falling. The benchmark Shanghai Composite Index (SCI) slid by nearly 3% to reach its lowest level in more than a year.
What factors result in the depreciation of the renminbi? In my view, it is caused by concerns for an economy that is slowing faster than expected, changes to the exchange rate policy, and declining foreign reserves. This puts Chinese policymakers in a difficult position: Should they stabilize the renminbi or their monetary policy?
The Reasons for Depreciation
The depreciation pressure comes from a gloomy growth prospect for China’s economy. Investments are hard to pick up given high inventory and excess capacity, especially in the real estate sector. Exports are contracting because of weak external demand. The proposed supply-side reforms, which include destocking, de-leveraging, reducing costs, and cutting overcapacity, will put more downward pressure on the economy. Concerns about deflation and rising debt have been lingering for a while.
In contrast, the US dollar is at an 11-year high, putting great pressure on the renminbi. Though other currencies have depreciated significantly against the dollar, pegging to the US dollar means that the renminbi has strengthened against these other currencies passively.
Because of these circumstances, the PBOC changed its exchange-rate policy twice over the past six months in order to better reflect the spot market price. In August 2015, it lowered the central parity rate against the US dollar by -2.8%; in December, it announced that the yuan’s exchange rate would begin to be measured against a basket of currencies rather than just the US dollar. The market interpreted these changes in renminbi policy as a sign that China’s economy was even weaker than previously thought, and both changes caused huge volatility in stock and commodity prices.
To stabilize the market, the PBOC had to intervene in the offshore (CNH) market and tighten controls on capital outflow. The cost is high: China’s foreign reserves fell another US$100 billion in January after already falling by US$500 billion by the end of 2015. Though China’s reserves are still the largest in the world at US$3.2 trillion, the rapid depletion raised doubts about the sustainability of the policy.
A Dilemma for China’s Policymakers
China’s policymakers are trapped in the impossible trinity — they cannot achieve a stable currency, the free flow of capital, and an independent monetary policy all at once. Since China has tightened its control on capital, it now must choose between stability in its currency or its monetary policy.
The policy in the past two months has reflected a swing from favoring policy to currency. In January, when the depreciation of the renminbi caused panic, capital outflow, and financial markets turmoil, the government had to stabilize the renminbi, which constrained the monetary policy. In worrying that too much liquidity would put more downward pressure on the renminbi, the government was reluctant to cut the required reserve ratio (RRR). Then, during the Chinese Spring Festival, Zhou Xiaochuan stated that China will take an opportunistic view of exchange-rate reform and will not let market sentiment be dominated by speculative forces. This was interpreted as meaning that China will attempt to stabilize the currency by postponing the exchange-rate policy reform and hitting speculations on the renminbi. On 15 February, the first trading day after the holiday, the central parity rate jumped by 0.3%, its largest growth rate since last November.
As the market calms down, China moves to shore up slowing growth. The purchase management index (PMI) slipped to 49% in February, the seventh straight month of contraction, suggesting continued downward pressure on growth. In response, the PBOC cut RRR by 0.5% on 1 March to free up more money for lending, causing the RMB exchange rate to fall slightly.
Theoretically, a more flexible exchange rate could help to eliminate one-way bets and act as an economic shock absorber. As Barry Eichengreen recently pointed out, however, China has missed its opportunity to exit the pegged exchange rate smoothly because there is no longer confidence in the economy. The least bad option for the government now is to push forward structural reforms to boost confidence in the economy as soon as possible. Then the reform on the exchange-rate policy could be considered. Before that happens, the renminbi will likely continue its bumpy road.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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