Besides all the current chaos in the global financial market, Chinese Yuan is definitely one of the few major concerns for government authorities, central banks and investors. China’s exchange rate policy has been rolling the market for months, and confusions about the policy has made the exchange rate of Yuan more volatile and unpredictable. This unpredictability also leads to an impression for the market that the Chinese government and the central bank have not actually found an optimal way to handle its currency and economy at the same time.
(Source: THE WALL STREET JOURNAL)
Sitting on the chair and making fun of the China’s exchange rate is easy, but offering constructive advice seems to be difficult. Obviously, China could be better off by switching to a more flexible exchange rate to beat speculators shorting the Chinese Yuan and to stabilize the domestic economy. However, the problem is that a smooth transition from a pegged to a floating exchange rate is challenging. Barry Eichengreen, professor of economics at the University of California at Berkeley, provides three possible solutions to this problem: continuing pegging the Chinese Yuan to a basket of currencies, allowing Yuan to fluctuate more freely but not dramatically or agreeing to a one-time large devaluation. However, none of these methods is optimal given China’s current economic situation.
Chinese government could remain its current policy of pegged currency while trying to speed up reforms to stabilize and boost the economy before the central bank uses up its foreign reserves. However, it will take a lot of time and efforts and the government will face a series of resistance both internally and externally. A lot of short positions in Yuan will be created by foreign speculators to anticipate mistakes made by China. Moreover, a massive capital outflows will happen shortly. In fact, capital outflows already reached $100bn a month last year and have started to accelerate since then. The major concern is that how long the Chinese central bank is able to hold and intervene the market given its current approximately $3tn foreign reserves.
Chinese Yuan could be allowed to fluctuate more freely and to deprecate in a moderate rate. Chinese government could decide to depreciate its currency against a basket of reference currencies in order to restore the competitiveness of its exports, reduce the risk of its overvalued currency and finally boost the domestic economy. However, there are two realistic problems this option is facing. Firstly, plenty of multinationals choose to switch their factories from China to other Asian countries such as Vietnam since Chinese labors are not relatively cheaper any more. Moreover, capital fight would accelerate without tighten capital controls. Hence, this slow deprecation could not help China to enhance its exports and improve the economy given the continued weak global demand.
The most intensive option is a one-time large devaluation. The people’s bank of China could devalue its currency right to a reasonable rate to restore net capital inflows instead of net outflows. One serious issue with this suggestion is that Chinese enterprises already have more than $1tn outstanding foreign debt, any significant devaluation would inevitably increase the burden on these companies and might cause a series of bankruptcy leading to social instability. In addition, this policy might also cause other countries to either start or continue to devalue their currencies to protect their domestic economies-finally a potential trade war? Who knows?
Interestingly, according to an interview published this Saturday in Caixin magazine, Zhou Xiaochuan, China’s central bank governor, said there was not ground for continued depreciation of the Chinese yuan since the balance of payments is decent, capital outflows are normal and the exchange rate is basically stable against a basket of currencies. In addition, he mentioned that there was no worry for potential tighten capital controls and the reduction in foreign reserves in the short run, and the bank would not let speculative forces dominate market sentiment. Zhou’s opinion seems to be totally opposite to what many speculators’ and economists’ thoughts given the increasing short positions in Chinese Yuan.
What will be happening next for Chinese Yuan? Everyone wonders but no one actually knows, even for the Chinese government. What we can do right now, may be just sitting on the chair with a cup of tea, and waiting for the moment to come.