In the first of this two part series, Stephen Grenville examined two of the three main concerns about China's economy, the financial sector and the rate of GDP growth. Part two focuses on the third aspect that has observers worried; the exchange rate and capital outflows.

Judged in fundamental equilibrium terms, both the IMF and think-tanks judge the current exchange rate for China's currency to be about right, but the political and market context complicates this simple assessment.

For the past decade or more the renminbi has been the subject of a continual barrage of US commentary complaining about unfair competitive advantage through an undervalued exchange rate. Perhaps reflecting this, the real (inflation-adjusted) value has risen 50% since 2005. The extent of the appreciation is such that many observers have become concerned the currency has overshot and is now over-valued. Even if this is the case, only a modest overshoot is implied: after all, China’s exports are going well considering the weak world market and the current account is still in substantial surplus.

The complicating factor is the deregulation transition. As capital controls have softened, Chinese investors have, understandably, bought more foreign assets in order to diversify their portfolios. In the second half of last year, capital outflow was running at an annualised rate around 10% of GDP. While this transitional portfolio rebalancing is taking place, the exchange rate is under additional pressure.

The combination of some concerns about an over-valued rate plus the capital outflows has the potential for dynamic instability: the capital outflow puts downward pressure on the exchange rate; in response investors (and speculators) increase their capital outflow.

The tiny ‘official’ devaluation last August should be seen as a market-based move in the right direction, as was the tentative move away from a dollar-based rate towards a currency-basket model. Measured against a basket of currencies (a better metric than simply against the appreciating US dollar), the renminbi has hardly changed over the past year.

Nevertheless the current exchange-rate policy is in an irreconcilable bind.

The small ongoing daily downward adjustments, while in the right direction, just give a one-way bet to speculators. China’s still-huge foreign exchange reserves are being leached away to slow the depreciation. Whatever the precise equilibrium value of the currency, the market has decided that it should be lower. The universal experience is that the authorities can’t successfully defend an exchange rate if the market has firmly decided that it is wrongly valued (the Swiss have provided a recent reminder), even if the market later turns out to have been wrong.

It’s hard for China to make a once-off depreciation which would be substantial enough to satisfy the market that the new rate is ‘right’. The usual US exchange-rate vigilantes (not to mention Congress) are ready to cry ‘manipulation’ and declare their own currency war. It would also be a face-losing step backwards on the deregulation path, especially coming just after the renminbi has been included in the IMF’s SDR currency basket. But if the problem is as intractable as financial markets imply, this is the best way out. China should make a once-off depreciation of 10-15%, adopting a fixed rate against a currency basket. This could be backed up by temporarily tightening capital outflow controls. This modest move shouldn’t discombobulate either the foreign critics or the domestic borrowers with dollar-denominated exposure. Deregulation is so tricky that the occasional step backwards is both forgivable and sensible. Deregulation can be resumed when financial markets have regained their composure.

China could respond to the inevitable critics by reminding them that it was foreign pressure (in the form of the 1985 Plaza Accord) that caused the drastic appreciation of the Japanese yen in the following years, which hollowed out Japanese manufacturing. This led in turn to the abnormally low interest rates that fuelled the Japanese asset-price bubble that finally burst in 1990. China’s circumstances are, of course, different, but the Japanese experience demonstrates that foreign pressures in volatile exchange markets can leave a legacy of distortions which hobble economic growth for decades afterwards.