200 years earlier, Napoleon is said to have remarked – “Let China Sleep, for when the Dragon awakes, she will shake the world.” What surreal wisdom…
China has clearly shaken the status quo of global economic dominion over the last 10 years. However, on the 11th of August, it shook up currency markets in a clear break from what was expected to be a one way trade. The People’s Bank of China (PBoC) raised the USD-CNY fix to 6.2298 from 6.1162. This was the biggest one-day move since the Yuan officially de-pegged from the U.S. Dollar in 2005.
China maintains a “soft” peg for the currency. The PBoC doesn’t let the currency float freely but rather lets it move within a band. This is called the “daily fix”. China establishes a target price for the Yuan and allows it to float as much as 2% from the target price. On August 11th, they shifted that target price 1.86% lower, the most since 1994. The PBoC also announced that it would henceforth change the way this target price – also known as “central parity”, would be determined. The central parity would be set on a daily basis as equal to the ‘closing rate of inter-bank foreign exchange market on the previous day’. Now, this is literally a regime change because the convention until then was to keep the central parity for each day at a level that was ‘thought to be appropriate’. Thus, in a way, Beijing has partially deregulated the exchange rate mechanism though a closer reading of the announcement makes it clear that the authorities would still intervene in foreign exchange markets.
So, why did they do it?
I’m so tempted to lead with one of those catchy “5 reasons why” lines and trust me – I almost did. Just that once you start thinking about what language to use instead of the idea, you’re pretty much screwed. So, in deference to simplicity, it boils down to 3 motivations
The trade factor: This is a goal that China would rather not talk about. It’s obvious that a cheaper currency can make a country’s exports more competitive and historically, devaluations have helped serve the purpose. In fact, a good two thirds of financial reports that I came across referenced the “currency war” idea at least once.
China continues to sustain a high current account surplus on account of exports persistently exceeding imports. However, there hasn’t been any good news in this area of late. A trade report that came in during the earlier weekend pointed to an 8.3 % decline in exports and 8.1% decline in imports for July. While analysts were quick to correlate the misery in trade statistics with the decision to devalue, correlation and causation do not mean the same thing. Now remember, the Yuan is quasi-pegged to the dollar and this automatically means that U.S. monetary policy gets imported to China. Ever since the Fed signalled its intentions to hike interest rates, U.S markets priced in the anticipated rate hike and a manifestation of this has been Dollar appreciation. So when the Dollar rises against other global currencies as it has in the past year, the Yuan also appreciates vis a vis its trading partners. Indeed over the past year, the USD and Yuan appreciated 20%, 25% and 12% respectively against the Euro, Yen and South Korean Won respectively. Mind you, these are 3 of China’s largest trade partners. Thus, maintaining a peg to the U.S. Dollar eroded export growth as China’s products became more expensive for importers outside of the U.S. Conversely, in China, a rising Yuan exerted further deflationary pressure as goods imported from countries that use currencies other than the Dollar became less expensive. There is hence some basis to the theory that a devaluation was intended to level the playing field in global trade and signalled the central bank’s belief that costs of pegging to the Dollar outweigh the benefits of a strong currency for now.
Qualify as a reserve currency by inclusion into the SDR: This is what China wants the world to talk about. There’s an increasing body of opinion that believes the PBoC’s actions are reforms that may pave the way for inclusion in the basket of currencies used to calculate IMF Special Drawing Rights (SDR). In fact, China has been campaigning for years to have the Yuan included in the SDR basket alongside the USD, EUR, JPY and GBP. Beijing’s push to move the Yuan into the group of reserve currencies is understandable for the change offers hope that significant foreign capital flows that will follow can reverse a persistent and relatively large capital account deficit. The strategy seems to be working because the IMF came out with the following statement after the Yuan devaluation.
“The new mechanism for determining the central parity of the currency announced by the PBoC appears as a welcome step as it should allow market forces to have a greater role in determining the exchange rate. […] Regarding the ongoing review of the IMF’s SDR basket, the announced change has no direct implication for the criteria used in determining the composition of the basket. Nevertheless, a more market-determined exchange rate would facilitate SDR operations in case the Yuan were included in the currency basket going forward.”
Now, does the IMF require a free float to back reserve currency status? A conceptual view (though not explicit) is that reserve currencies ought not to be highly managed. Significant deviations from underlying fundamental value that are common in such cases are viewed as ripe for instability. One need only look back to a spectacular turn of events that forced the Pound out of the ERM back in 1992, a story that has often been glamorized by the cult of George Soros.
Discretionary monetary policy: In here, we have a fundamental premise – one that goes beyond any current event. A common concern among many an analyst is that China has been violating a principle known as the “Impossible Trinity” or “Policy Trilemma”. The Nobel Prize winning economist Robert Mundell, put forward the maxim that a country cannot have a fixed exchange rate, independent monetary policy and free flows of capital at the same time. One of these has to give in. In effect, a central bank has only three policy combinations that it can deal in
- A fixed exchange rate and free borders for capital flow,
- An independent monetary policy and free capital flow, or
- A fixed exchange rate and independent monetary policy.
It so happens that China was attempting all three objectives to varying degrees. First, there was a quasi peg of the Yuan to the dollar. In the monetary policy department, PBoC has been busy, pushing through a slew of interest rate cuts and bank reserve ratio reductions since late 2014. Being passive was never an alternative available as it had to contend with a slowdown, credit crisis and deflating property bubble. However, capital mobility is where the Policy Trilemma rears its ugly head. I’m a history buff and believe me – a look back in time will be worth the effort to understand the present conundrum.
Not too long ago, the Chinese were insulated via capital controls. Back in the late 90’s when Asia was roiled by the financial crisis, almost every South East Asian neighbour suffered from short term destabilizing capital flows and resulting currency mayhem. Of course, the impossible trinity was at work – currency pegs, high interest rates and free capital accounts were the reason that hot money flooded into South East Asian assets in the first place. China though was insulated as the Yuan exchange rate was fixed and there were limits on foreign investment in domestic assets. The capital account was relaxed in the early years of the new millennium but shackles still held firm upon the onset of the 2007 crisis. This meant that the Impossible Trinity was not at play. Post 2007 however, China’s reliance on international funds has risen. And why would that be so ? For one, the Yuan rode into appreciation territory. More importantly, the Fed’s QE program created perfect conditions for abundant hot money to flow into China. But it wasn’t just the U.S Fed that was easing. Japan was experimenting with its own version of QE under Abenomics. The carry trade had begun and a strong currency offered just the right mix of conditions. In fact, China’s shadow banking system was propped up by global capital flows that sought higher yields. Even as the Fed decided to end the QE party and the famed taper tantrums played out in 2013, China was spared. In stark contrast, most other Asian currencies got hammered. Markets were convinced that Beijing would do everything in its power to keep the Yuan strong and safe heavens are always priced highly in turbulent times.
The problem now is that the money that found its way into China during boom times is actually starting to reverse course. An unwinding of the carry trade is underway. According to JP Morgan, capital outflows—the net amount of assets leaving China—totaled $450 billion in the past four quarters, after adjusting for changes in the valuation of foreign exchange reserves. In an earlier post, I’d written about Beijing’s moves to prop up the stock market index by sheer brute force. It would hardly surprise me if those actions did not cause more capital leakage.
So, the predicament today is that the PBoC cannot leverage monetary policy to support the economy and borrowers struggling with debt burdens without triggering a flight of capital out of its porous borders. Here’s a very succinct portrayal by David Beckworth in this very engaging commentary;
“Since China desires its currency to become fully convertible in the future and because party leaders in China are unlikely to give up control of domestic monetary policy, it is almost a given that the adjustment to Chinese policy would have to come through a change to the Yuan exchange rate. So this is the deeper reason for the devaluation. And it is the reason that the devaluation is probably just the first step toward an eventual floating of the Yuan.”
I don’t have any special knowledge of what the PBOC has in mind with this regime change but I suspect neither do many experts. A few years ago I came upon this quote etched on a random board “insincerity is always weakness. Sincerity even in error is strength”. In a show of sincerity, I thought of deferring to a good friend from the bond markets on the topic. Bond market shenanigans have made an art out of deciphering central bank pronouncements. Out of sheer respect, there I was, sitting back and taking notes when we finally started on the topic of which one of these motivations drive the PBoC’s move.
Despite its simplistic appeal, he didn’t find the foreign trade angle very convincing. He had a point – as per the broad measure of BIS effective (trade weighted) exchange rate, the Yuan has appreciated by some 30% over the past five years. A depreciation of 2% simply pales in comparison. It’s like bringing a knife to a gunfight. He believed that it was the desire to gain more monetary freedom in the first place and a subsidiary intent to qualify for the SDR bucket that prompted the change. However, he had a parting warning to offer. When authorities start reacting with a slew of measures as we’re seeing today, it’s only prudent to infer distress signals. That the Chinese economic engine is sputtering is not doubted anymore. But it probably is weaker than the 7% a year GDP growth that is made out in official statistics. As I mentioned in my last post, the two pillars of the Chinese economy till date have been manufacturing (largely export driven) and investment growth. However, China is now transitioning to the new normal where demand will increasingly be driven by domestic consumption and the economy will soon have no option but to get off the treadmill of steroidal credit growth. Could it be that policy makers are running out of patience and in a frantic search for results, returning to the all too familiar cuddle of a cheap currency? Beijing calls this a one time adjustment. These are interesting times indeed.