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The Indomitable Renminbi

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From the Summer Issue "Change Matters"

By Donald Straszheim

BEIJING—A typical Chinese tourism website advertising a week in New York City including three days of sightseeing, one day of shopping on Fifth Avenue, and one day looking at real estate investment opportunities—condos preferred, and ideally of the luxury variety. Chinese tourists, admittedly not the poorest segment of this society, now outnumber and outspend American tourists. And when they return home, they regularly comment about the overseas “bargains” they found. Even for ordinary Chinese who’ve never ventured abroad, the prices of overseas products continue to fall. Many have come to accept a constantly strengthening currency as the natural order.

Any number of small mom-and-pop enterprises in China have found anything they sell from the West regularly falling in price. And as the dollar fluctuates against the euro or Japanese yen, Chinese shop owners find their cost of merchandise from third countries also rising and falling. To the small enterprise owner, stronger means cheaper imports, while weaker means more expensive imports—a lesson easily learned. They may know little about the deliberations of the U.S. Federal Reserve, the Bank of Japan, or even the People’s Bank of China (nor do they really care), but they know when costs are falling or rising at their own establishments. And with the yuan, or the renminbi as it is also known, poised to take its rightful place as a global reserve currency, money will play an ever more dominant role in the consciousness of every Chinese.

The concept of a reserve currency would mean the yuan would be freed entirely to float and trade on the whim of the international traders from New York to London to Tokyo—a sharp contrast to the current “managed floating exchange rate mechanism,” that has made life much more predictable to most Chinese these days. Since mid-2005, the yuan has appreciated about 30 percent against the U.S. dollar, and at a relatively smooth rate. As a result, the cost of a product imported from Europe, or a trip to visit the United States, would have declined by that 30 percent. For that matter, buying such assets in the United States as an offshore home as security would also have fallen by 30 percent.

Without controls on the yuan, though, prices and costs would be moving all but unpredictably, so timing any hypothetical future trip, or indeed any purchase, would become important—and difficult. That extra timing risk is not one that any business owner or family budgeter really welcomes. It is another factor that a Chinese government, increasingly sensitive to popular opinion, must take into account.

GROWING FASTER

China’s economy is now approximately the same size as that of the United States, and enjoying the world’s fastest economic growth rate over the last 30 years. But China’s breakneck growth rate is slowing, and structural imbalances in the economy are developing. All this will require policymakers to pay close attention and make some hard decisions. Fundamental economic and financial reforms are in the air. Currency reform is one of the agenda items. And currency reform is all about global finance, likely Beijing’s weakest suit.

Though the Chinese government started down the path of exchange rate reform in July 2005, it has never moved beyond the point of targeting a “basically stable” exchange rate regime that gradually becomes increasingly more market driven. The nation’s leaders have not committed to pursuing a freely floating exchange rate. Beijing’s focus on stability and on maintaining control of its own economy rules out the boldest currency reforms for the foreseeable future. With the United States, the eurozone, and Japan all pursuing experimental (not just unconventional) monetary policies—the risks of economic and financial instability and doubt can’t be far below the surface in Beijing.

These conditions do not commend a freely floating currency for an economy like China’s with a giant trade sector, big foreign direct investment both inbound and outbound, and an under-developed financial sector that is still best described as archaic. And without a currency that is free to float, it will never become a true reserve currency like the dollar, euro, yen, or pound sterling.

Of course, if Beijing decides to introduce more two-way variability into its currency, ultimately moving toward a freely floating yuan, the ups and downs of the currency movements will have greater day-to-day immediacy and consequences. Hedging bets against currency moves will become more important. But over the longer term, whether the yuan is a persistently appreciating or depreciating currency will be of paramount importance. Some of the policy elite might believe a freely floating yuan brings them some global prestige. But, by itself, that would assure neither growth nor stability. It would assure neither price stability nor inflation.

In a smooth, joint process, China’s leadership turned over in 2012 (the Communist Party) and in 2013 (the government)—the latter having existed since its creation in 1949 as an instrument of the former to run the country in the Party’s best interest. Nine more years in office is the best bet—four years remaining in the current term and five additional years of a second term—assuming recent practices continue. Nine years is a long runway with time for real reforms along many fronts, especially currency and finance, which is less about facilitating either currency appreciation or depreciation, both of which have their postives and negatives. Rather, it is about risks along the reform path itself and the consequences of loss of economic control to outside agents. Most importantly, when contemplating the reform path, Beijing officialdom wants to ensure that the benefits outweigh the costs, that the worst-case downside risks are minimal, and that the public is on board with whatever changes are made, start to finish. To date, outside observers have been much more enthusiastic about China launching basic currency reforms than has the policy elite within China.

MANAGING THE FLOAT

China’s currency was pegged to the U.S. dollar from 1997 to 2005. China abandoned this currency peg on July 21, 2005, revalued the currency by 2.1 percent, and adopted what they described as a “managed floating exchange rate mechanism.”

At the time, the central bank, the People’s Bank of China, indicated it would manage the currency “with reference to a basket of currencies,” while neither specifying the currencies in that basket nor the currency management process. Indeed, they were under no obligation to do so. It became obvious within a few days that this new mechanism was more managed than floating. At the time, July 2005, the central bank made it clear the revaluation was a one-time event. That guideline stands to this day.

The yuan gradually appreciated over the next 39 months. But, in October 2008, Beijing effectively re-pegged the currency as the global economic crisis was unfolding. Beijing’s rationale was simple. Its export markets were suffering from weak overseas demand as the world’s consumer sat on their wallets. And they didn’t want to make trade prospects even worse (the top concern at the time) by allowing the currency to appreciate even further.

As the global economic storm and financial turmoil ebbed, Beijing let the yuan resume its previous rise in June 2010, only to call a halt again in November 2011 as the euro crisis unfolded. The rationale was largely the same as in October 2008—a weaker global growth means weaker exports, a situation to be avoided. Then in October 2012, Beijing again let the currency begin to rise gradually in value as the euro crisis looked to be contained.



While some countries have repeatedly complained about Beijing’s management of its currency, China’s policy elite, its business and financial community, and ordinary citizens had no complaints on the central bank’s performance in managing its currency. China’s GDP grew at over 10 percent annually. Inflation was held to 3 percent, and foreign investment showed inflows year after year while its trade surplus averaged 4.4 percent of GDP.

Not surprisingly, Beijing is quite passive about the size of its foreign exchange reserves, which reached about $4 trillion in early 2014. Instead, it is more concerned with the components that are driving up the reserves—in particular, those flows that are outside of trade and direct investment. For this reason alone, any moves by China to relax its grip on the yuan will be cautious and slow, not bold and quick.

The “made in America,” as China sees it, global economic crisis of 2008-09, and the euro crisis of 2011-12 were the first two external economic and financial episodes that had any material effect on China’s economy since the reforms and opening up of Deng Xiaoping in 1978. The managed currency, the state-owned banking system, the protected and largely closed capital markets, and the state-dominated industrial system largely insulated China from storms that could have overwhelmed its financial markets.

These lessons still resonate today. When it comes to the big decisions, China’s economy remains more command-and-control driven than market driven—and this system works. GDP in 2008-09 in the United States, the eurozone, and Japan, at their worst, fell by more than 5 percent. The rest of the emerging markets did not do much better. But China’s economy bottomed out at around 5 percent GDP growth—far less damaged. So while China launched its currency reforms in mid-2005, at a measured pace that is too slow for some, the currency has strengthened about 30 percent over the last nine years. Beijing can be counted on to be cautious, not adventurous, in making economic reforms. Any steps that involve giving up economic control to overseas interests will have to get over a high hurdle of benefits versus costs.

NEW REFORMS

China’s new top official, Xi Jinping, president and head of state, as well as General Secretary of the Communist Party of China, has announced a bold and broad reform agenda in a so-called decisions document made public in November 2013. It enumerates “60 Concrete Tasks”—economic, social, cultural, legal, and more—with currency reform featuring prominently. It orders increased market-driven trading in the yuan, opening capital markets to the outside world, and “accelerat[ing] the realization of [yuan] convertibility under capital account.” The document also pledges that by 2020 the markets will play a “decisive” role, whereas previously the markets played only a “basic” role. Neither term has been defined by the nation’s leadership, which has pointedly made this distinction a tangible commitment, allowing the markets to interpret and apply.
Beijing thinks of its currency policy with reference to several other basic financial reforms—interest rates (both deposit and lending), a banking system that is more market driven, a new deposit insurance system in the banks, a robust treasury debt market, a real corporate bond market, more open cross-border flows, an equity market that has the trust of the people, and a management system of some sort. This is an understandable financial sector laundry list of reforms.

Beijing is fond of reform pledges to “deepen,” “broaden,” “perfect,” and “improve,” but only incrementally. A freely floating currency would expose China to potentially massive flows of speculative capital, or hot money. Such a policy lurch is the last thing on Beijing’s mind.

BASICALLY STABLE

China’s practice has been to use a consistent while general description of its currency policy over many years. Not unlike systems used by central banks from the Federal Reserve to the Bank of England and the European Central Bank, as the public has become accustomed to its style, Beijing feels it can change policy considerably without creating waves of new expectations. “Basically stable” is the long-standing characterization—back to China’s economic crisis in 1997-98. Former Prime Minister Wen Jiabao, in 2003, talked of “keeping the currency ‘basically stable.’” This language encompasses the fixed exchange rate period, 1997 to 2005, and the period from 2005 to the present when the yuan has been allowed to float within a range.

Indeed, the yuan has weakened more against the dollar in the January-May 2014 period than at any time prior to when the currency was pegged to the dollar in 1997. The approximately 1 percent fall in the yuan is small when compared to freely floating currencies, but large by contemporary Chinese standards. The Chinese economy has begun to struggle and slow, just as structural problems beset China’s housing and industrial state-owned sectors and as China’s non-bank financing has grown rapidly for many years.

Recent changes in China’s currency policy represent another incremental step toward reform, not a fundamental change in policy. For the last 20 years, Beijing has tied its currency and its economy to the United States. There could have been no lower-risk course for a big, industrializing economy like China. And while the appreciation of the yuan has been approximately 30 percent since 2005, it has been in small, gradual steps.
But in 2013, investor sentiment congealed around the view that China’s currency was a one-way bet—it would persistently rise. Increasingly uncomfortable with this consistency, which in theory allowed bets against it, the central bank lowered the exchange rate beginning in mid-January 2014, raising fears that the long-term rise in the yuan might be over. As the bank expected, heavily leveraged investors panicked, and the spot rate fell dramatically in two months on what was effectively a gray market. During that period, the Bank of China widened the daily trading bands, further unsettling speculators.

A debate persists among market participants and policy analysts as to whether the recurrent appreciation of the yuan versus the dollar over the last nine years has been reversed. Such a reversal would be an immediate high-risk path for Beijing. The low-risk path is the one Beijing seems to be taking—introducing some risk into this market, but only so much. If global investor sentiment concludes that China’s economic and financial problems are not manageable, an effort by the Bank of China to lower the exchange rate a few percent might turn into an avalanche of selling pressure and a source of significant potential instability, an outcome Beijing most wants to avoid.

It is also worth remembering that a widening of the daily allowable trading bands says nothing about the future central parity rate to be set by the central bank. It seems unlikely that the bank would be contemplating a further near-term widening of the daily trading bands.

ACCELERATING REFORMS

Five broad pre-conditions will determine the pace of China’s ongoing currency reforms. First, the expected benefits must be regarded as far superior to a continuation of the status quo. Second, there must be minimal downside risks in a worst-case reform scenario. Third, domestic economic and financial conditions must be strong and promising. Fourth, foreign economic, and financial conditions must not be materially in doubt. And fifth, Beijing must be confident that it can execute reforms. But do the expected benefits sharply outweigh a continuation of the status quo? At this point, there is no clamor among ordinary Chinese, or even among the business and professional classes, for currency reform as an essential near-term ingredient in China’s ongoing economic advance. The reforms of the last nine years have been modest and managed. Stability and predictability have not been in doubt. And when the global crisis was brewing in 2008, or the euro crisis in 2011, Beijing backpedaled and re-pegged the currency for a time. Few objected to these detours. The vast majority of Beijing’s policy elite, including most of the current ruling class, have been pleased with China’s currency management.

There is no strong market consensus whether the Chinese yuan might strengthen or weaken against the dollar or any other major currency. Its movement would, by definition, create winners and losers—but at what cost to stability and how might this play out over two or three years, let alone the long-term. There’s considerable doubt whether China would even be better off compared to the stability and control of recent years. If the positives do not markedly outweigh the potential negatives, the pace of reform is likely to be slow.

And currency reform must be fitted into the other business and finance reforms. Above all, Beijing will need to sell its currency and additional reforms to the Chinese public, even under its current centrally-planned and directed system. The vested interests in China are as powerful as anywhere in the world. The private business community in China only somewhat buys into the net benefit of expanded market forces, and the state-owned sector even less. In state-owned industrial enterprises, giving up control is the last thing Beijing wants or even feels it needs. Since 2005, the emphasis has been on “managed” rather than “floating.” Accelerating this process will not come quickly. Nowhere in the concept “basically stable” has Beijing talked of a freely floating exchange rate mechanism.

Additionally, the downside risks to a more flexible exchange rate system are hardly minimal. In 2008-09, worldwide, both market movements and policy reactions were more extreme and abrupt than ever imagined. In retrospect, for China to have weathered this storm under a more flexible exchange rate mechanism now seems unlikely. China is a huge exporter and importer, and based on World Bank measures could displace the United States from the number one position it’s held since 1872. China’s growth rate has been second to none over the last quarter century. Some 500 million Chinese have
made 8 percent annual income gains for the last 25 years. Any step that might, by inadvertence or mismanagement, yield more instability and involve Beijing giving up economic control is, in the government’s view, a step not worth taking.

However, domestic economic and financial conditions in China hardly appear strong and promising. Growth has been slowing for the last three years, with longer-term growth prospects decidedly lower. Productivity gains are set to slow year after year, and the working-age population has already peaked, with annual declines likely to increase over a multi-year period. China’s banking system remains dominated by state-owned banks that are not fully market oriented and do not yet have a deposit insurance system, though that reform is under discussion. Lending rates were deregulated in July 2013.

Deposit rates remain under state control, although with more flexibility than in years past. China’s bond markets are still far from developed. The securities industry in China is dominated by state-owned enterprises that are little more than employment agencies. China’s fiscal arrangements—central and local—are a long way from settled and stable. The central bank has only a few years experience with the ups and downs of market forces. The non-bank finance industry, sometimes loosely referred to as “shadow banking” or “wealth management products” in China, has ballooned in recent years, but is not yet ready for prime time. Before further currency reform can move forward, these major challenges must be addressed.

Foreign economic and financial conditions hardly promise a smooth path for a China headed toward a freely floating currency. The United States, Europe, and Japan are pursuing experimental monetary policies that have, bluntly, unknown consequences. None has addressed its structural budget imbalances that promise to get dramatically worse. Japan’s longer-term prospects are grim. No one knows how Japanese Prime Minister Shinzo Abe’s economic stimulus plan, popularly known as “Abenomics,” will work out. The United States and Europe are doing a little better than during their worst recent years. But all three of these big economies are pursuing one version or another of quantitative easing, with zero interest rate policies, in an attempt to export their way to stronger growth. The upshot is funds are trying to flee zero interest rate regions with depreciating currencies, seeking higher interest rates and potentially appreciating currencies. This is not an equilibrium situation. Such a situation might be singularly difficult for a country like China that is, step-by-step, opening itself up to the potentially massive flows and volatility of the global markets.

Finally, there’s some question whether China has the depth of leadership, experience, and bandwidth to tackle all the challenges it’s now facing.

Certainly its energy and environmental reforms may be more important than all others combined. But its housing sector is massively out of equilibrium, while its state-owned industrial sector is inefficient and seems likely to lose ground in the global competition for growth every year. None of these issues is simple. All face the inertia of vested interests and will require Beijing’s best balancing act to pull off. Even with an invigorated and enthusiastic new leadership team in Beijing, these various market-oriented reforms are quite outside Beijing officialdom’s experience and comfort zone.

In the end, none of this is to suggest that Beijing should suspend all currency reforms. In the long run, the more decisions that can be left to the invisible hand of the marketplace, instead of to the visible hand of Beijing officialdom, the easier the task will be—and the better the outcomes. But it does suggest that the currency reforms should be especially deliberate, and that they follow many of the other reforms in the financial marketplace—not precede them.

*****

*****

Donald Straszheim is senior managing director and head of China research at International Security & Investment Group.

[Photos courtesy of Chris via Flickr and LuuLuu via Flickr]
 

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