It wasn't so long ago that China was being accused of holding its currency down to boost exports. So it's ironic that the issue likely to dominate the G20 Finance Ministers Meeting in Shanghai on 26-27 February is how to deal with the ongoing depreciation of the Chinese exchange rate.
On 9 November 2015 Donald Trump claimed that the worst of China's sins was 'the manipulation of China's currency, robbing Americans of billions of dollars of capital and millions of jobs'. He said that on day one of a Trump administration, the US Treasury Department would designate China a currency manipulator and impose duties on Chinese goods. Trump was a little out of date. The IMF had indicated in May 2015 that China's currency was no longer undervalued.
More recently there has been a major outflow of capital from China, putting downward pressure on the yuan. This reflects growing concern over China's growth fundamentals, unease over attempts by the authorities to intervene in markets and the increasing realisation that the currency has but one way to go; down.
Rather than intervening to hold the currency down, the People's Bank of China (PBoC) has spent a significant amount of its reserves in an effort to offset the fall in the renminbi. The PBoC spent close to US$500 billion in the past six months supporting the currency. While China continues to have the largest holdings of international reserves of any country at just over US$3 trillion, currency traders believe the intense intervention by the PBoC is unsustainable. There was once a view that China's reserves were so vast that the PBoC could set the value of the yuan wherever it liked. This is no longer the case. China cannot indefinitely burn through reserves at over $US100 billion a month.
So what can China do?
Another irony is that within weeks of the IMF announcing that the yuan would join the basket of currencies determining the value of the Special Drawing Right, a sign that China's currency was now considered to be freely usable, the Governor of the Bank of Japan, Haruhiko Kuroda, led a series of calls on China to tighten capital controls to stem the outflow of money and reduce the relentless downward pressure on the currency.
Reintroduction of capital controls would have to be carefully handled, particularly given the recent less than successful attempts by the authorities to intervene in markets. Attempts by the authorities to control capital outflow may raise investor concerns over China's broader policy intent and result in even greater pressure for capital outflows.
Moreover, as Eswar Prasad, the former head of the IMF's China division, has noted, capital controls alone will not inspire confidence in the outlook for the economy and the authorities' policy intent. On that front, there is no substitute for policy action.
Another option China could follow is to let the currency go. It will overshoot, but will find its market level and in doing so will break the persistent expectation of a depreciation which is driving capital outflow. In addition, because China has not yet fully opened its capital account, corporate foreign debt is not large and currency mismatch is small. A large depreciation will not cause domestic financial concerns.
But a major depreciation in China's exchange rate would cause significant volatility in world capital markets and lead to accusations that China is pursuing a competitive depreciation at the expense of other countries. China has already been accused of being at the front line of a currency war.
A recent report from Bank of America Merrill Lynch called on the forthcoming G20 Finance Ministers Meeting to endorse a one-off devaluation of the Chinese exchange rate, a ‘commitment for a stable dollar’, new swap lines for emerging markets, and fiscal stimulus by France, Germany and the UK to prop up flagging world growth and avoid financial panic. However the authors are not hopeful of such an outcome, saying ‘our deep concern is that the macro and the markets may first need to worsen to inspire the correct policy response’.
Mike Dolan from Reuters is closer to the money in suggesting that the Shanghai G20 Finance Ministers meeting will likely stick to the well-established script in dealing with global currency tensions. Just like previous meetings, there will likely be commitments to ‘monitor financial market volatility and take necessary actions’, along with ‘carefully calibrated and clearly communicated’ policy settings in order to minimise negative spillovers and resist protectionism. But notwithstanding the rhetoric, the meeting is unlikely to result in any country doing anything differently.
As chair, it is likely to be a difficult meeting for China. Premier Li Keqiang recently phoned the IMF Managing Director, Christine Lagarde, pledging to keep the Chinese currency ‘basically stable’ and improve communication with financial markets. China can certainly improve on how it communicates its policy intent, but regardless, 2016 will likely be a rocky year for the yuan.
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