The People’s Bank of China (PBOC), it seems, cannot win.
In late February, the gradual appreciation of the yuan was interrupted by a 1 percent depreciation (to 6.12 yuan against the US dollar:). Though insignificant in overall trade terms, especially when compared with the volatility of floating exchange-rate regimes, the yuan’s unexpected weakening sparked a global furor.
The uproar was not surprising. After all, China has been under constant pressure from foreign governments to revalue, in the mistaken belief that a stronger currency would reduce China’s large trade surplus. And, since July 2008, when the exchange rate was 8.28 yuan to the US dollar (and had been held constant for 10 years), China’s central bank has more or less complied, with appreciations approximating 3 percent per year through 2012.
However, the international outcry obscured an unintended, but perhaps more troubling, feature of China’s exchange-rate policy: The tendency for sporadic yuan appreciation (even small movements) to trigger speculative inflows of “hot” money. With short-term interest rates in the US near zero and the “natural” interbank interest rate in faster-growing China at almost 4 percent, an expected 3 percent appreciation, for example, translates into an “effective” interest-rate differential of 7 percent. This is an enticing spread for currency speculators who borrow in dollars and circumvent China’s capital controls to buy yuan assets.
The hot-money problem is only made worse by the ongoing international pressure for further yuan revaluation, usually from Western economists and politicians who blame the exchange rate for China’s current-account surplus with the US and other developed economies.
The trade imbalance reflects the difference between China’s large savings surplus and the even bigger US saving deficiency (largely explained by the US fiscal deficit). The wholesale price index — the best measure of tradable-goods prices in China — has been falling by about 1.5 percent annually, which suggests that the yuan may even be slightly overvalued.
GETTING HOT IN HERE
Simply put, exchange-rate movements do not properly correct net trade (saving) imbalances between open economies; but they can increase hot-money flows. So China’s central bank tried to keep speculators off guard by introducing more uncertainty into the exchange-rate system, as occurred with February’s surprise devaluation. In the middle of last month, the bank said that the daily movement in the yuan/dollar rate would be increased from about 1 percent to about 2 percent, to further dampen hot-money speculators’ enthusiasm. While this is all well and good, speculative inflows would be further dampened if today’s central rate, say, 6.1 yuan to the US dollar, was stabilized into the indefinite future.
There is less-discussed justification for holding the currency at a stable rate. The adjustment mechanism usually provided by exchange-rate movements could instead be delivered by wage changes. It is only in more sluggish industrial economies, where wages are assumed to be inflexible, that policymakers advocate exchange-rate movements as a means to overcome wage stickiness.
However, in rapidly growing emerging markets, wages are often sufficiently flexible on the upside. For example, if an employer (particularly an exporter) fears future yuan appreciation, he may hesitate to raise wages in line with productivity increases, in order to keep his costs under control. However, if he can be confident that the exchange rate will remain stable, he will not need to restrain wages — and China has experienced 10 percent to 15 percent annual wage growth already. With faster wage growth at a stable nominal exchange rate and by encouraging unit labor costs to converge to those in developed economies, China’s real international competitiveness would be better calibrated.
As a result of policymakers’ heavy focus on the exchange rate, China’s State Administration of Foreign Exchange has now accumulated more than US$4 trillion in reserves — far exceeding the amount needed to cover any imaginable currency emergency. Worse, the very act of currency intervention can undermine the bank’s control of monetary policy. Buying dollars increases the domestic base money supply, risking inflation and asset-price bubbles.
Efforts to “sterilize” these purchases and dampen domestic credit expansion also have adverse consequences. The bank frequently does this by selling bonds to commercial banks or raising reserve requirements for them. However, this has reduced these banks’ effectiveness as financial intermediaries, while encouraging the rise of so-called “shadow banking” to circumvent the restrictions.
What, then, are the central bank’s options?
One approach might be simply to let the yuan float without official intervention or controls on capital inflows. Again, this would inevitably trigger hot-money inflows, with speculators taking advantage of the spread between Chinese interest rates and the near-zero, short-term rates in developed economies, thereby driving up the yuan further (and creating yet more opportunities for speculation). There would be no well-defined market equilibrium, or upper bound, for the yuan/dollar exchange rate
CATCH-22
Even without hot-money inflows, the yuan’s exchange rate would face upward pressure, owing to the absence of corresponding outflows to finance the trade (saving) surplus. As an immature international creditor, China is unable to balance the inflows by making yuan loans abroad. Nor would it want to make dollar-denominated loans. Private banks, insurance companies, pension funds and so on have limited appetite for building up liquid dollar claims on foreigners when their own liabilities — deposits, insurance claims and pension obligations — are denominated in yuan. The potential currency mismatch would require the central bank (which cares little for exchange-rate risk) to step in as the international financial intermediary and buy liquid dollar assets on a vast scale.
Moreover, foreign investors remain reluctant to borrow from Chinese banks in yuan, or to issue yuan-denominated bonds in Shanghai. That will remain true as long as they fear continued outside political pressure to appreciate.
China is therefore caught in a currency trap, owing to its own saving surplus (and the US’ saving deficiency) and near-zero interest rates on dollar assets.
Although fully liberalizing China’s domestic financial markets and “internationalizing” the yuan may be possible one day, that day is far off. For now, if China tries to liberalize its financial markets, hot money will flow the wrong way — into the economy, rather than out.
Thus, China must maintain controls on inflows of financial capital for the time being, with the central bank intervening to stabilize the yuan/dollar exchange rate. Until conditions in the world economy improve substantially, China’s policymakers will have no easy way out. However, even if they are constrained, the economy can continue to grow.
Ronald McKinnon is a professor emeritus of international economics at Stanford University.
Copyright: Project Syndicate
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