China must overcome the fear of yuan depreciation

By Yu Yongding Source:Global Times Published: 2018/8/23 20:23:40

Illustration: Luo Xuan/GT


At a seminar at Fudan University in Shanghai in December 2016, I argued that it doesn't matter whether or when the yuan would weaken beyond 7.0 to the US dollar, but it would matter if the nation massively depletes its foreign exchange reserves without justified causes.

In international economics there is the famous concept of an impossible trinity, which states that a country cannot have an independent monetary policy, an open capital account and a fixed exchange rate at the same time, and it can only have two of the three. In comparison, at the moment, China is facing an impossible quaternity: Among exchange rate stability, preserving foreign exchange reserves, monetary policy independence and national creditworthiness, China can only have three of the four. In my view, the best choice is to give up exchange rate stability and have the remaining three.

China started to speed up the liberalization of the capital account in 2012. It was argued at the time that China was having a strategic period of opportunity for the liberalizing capital account. However, since the second half of 2015, confronted with the surge of capital outflows, sentiment changed abruptly and the view that China should tighten capital controls gained the upper hand.

To tighten capital controls was absolutely necessary. Nevertheless, if China sticks to an inflexible exchange rate, the burden of the containment of capital outflows would fall entirely on capital controls, which would force the monetary authority to tighten capital controls to such an extent that it has to go back on many promises it had made on freer movement of cross-border capital flows. If this happens, China's international credit would be damaged badly. Instead, if China had a flexible exchange rate, as an automatic stabilizer, the fall in the yuan would reduce capital outflows, due to the rise in the domestic prices of foreign currencies. In other words, a flexible exchange rate would reduce the necessity for the further tightening of capital controls, and make China's international credit less likely to be compromised.

Then there is the question of the choice between defending exchange rates and preserving foreign exchange reserves. In 2015 and 2016, to stabilize the yuan, the central bank intervened in the foreign exchange market constantly. In a period of less than two years, China spent some $1 trillion. Some argued that without the intervention, the yuan would have a precipitate fall and hence it was money well spent. The argument is wrong on three accounts. First, the costs for the maintenance of exchange rate stability were too high. During the Asian financial crisis in the late 1990s, the total amount of resources that the IMF and other institutions pledged to provide to Thailand, South Korea and Indonesia was just $120 billion. In fact, after the doubling in 2016, the total resources commanded by the IMF stood at $1.363 trillion. Second, the foreign exchange reserves spent failed to translate to an equal amount of private foreign assets held by Chinese citizens. The money just went missing from China's international balance of payments table and international investment position table. Third, there was no evidence whatsoever that the yuan would have collapsed, if the government had not intervened. This view overestimates the impact of depreciation expectations, while underestimating the self-stabilizing effect of a flexible foreign exchange rate as well as the role of economic fundamentals. Although depreciation expectations strengthened by actual depreciation may cause overshooting, with China's strong economic fundamentals it is difficult to imagine how the yuan would collapse.

Even if the yuan devalued very deeply, would a financial crisis follow? A financial crisis led by currency depreciation is related to four problems of an economy. The first is a currency mismatch between domestic and foreign currencies in the banking sector; depreciation will worsen banks' balance sheets and lead to a banking crisis. But in China, foreign currencies only account for a very small fraction of China's bank funds, rendering the concern unnecessary. Second, if a company has a massive amount of foreign debt, the cost of debt in domestic currency terms may shoot up as a result of devaluation, which in turn would plunge the company into a debt crisis. China's corporate debt as a percentage of GDP is more than 150 percent, but Chinese companies' foreign debt as a portion of total corporate debt remains quite low. Third, if a country has large sovereign debt, devaluation may lead to a sovereign debt crisis. But China's sovereign debt is very small. Fourth, devaluation will worsen a country's inflation. China's inflation in 2016 was hardly a serious concern; instead the nation was facing producer price deflation at the time.

The yuan exchange rate stabilized in early 2017 and started to appreciate. Was it a result of the policy aimed at stabilizing the yuan exchange rate implemented in 2016? My view is that with or without the intervention in 2016, the yuan exchange rate would have stabilized anyway, because of the fall in the US Dollar Index and the improvement of China's economic performance.

With the benefit of hindsight, the loss of $1 trillion from 2015 to 2016 was not only unwarranted but also unnecessary. If there had been no intervention in the foreign exchange market, the yuan would have depreciated but a substantial fall was highly unlikely.

Although abandoning intervention would lead to some instability in the exchange rate, economics still tells us that we can only opt for the least-worst choice among all possibilities and it's unlikely that we can pick an absolutely safe bet. Now the yuan depreciation pressure is rising and the exchange rate is approaching 7 per US dollar again. After having learned a costly lesson in the previous round of depreciation, hopefully the decision-makers as well as the market participants will treat the current round of rising depreciation pressure in a much calmer way.

The author is an academician and senior fellow of the Chinese Academy of Social Sciences.


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