• Mon
  • Dec 29, 2014
  • Updated: 9:53am


The Chinese yuan, also known as the renminbi, is already convertible under the current account - the broadest measure of trade in goods and services. However, the capital account, which covers portfolio investment and borrowing, is still closely managed by Beijing because of worries about abrupt capital flows.


What exchange rate policy?

Adherence to the status quo is the guiding principle for exchange rate officials on the mainland, where just muddling through trumps strategy

PUBLISHED : Monday, 10 March, 2014, 12:54pm
UPDATED : Tuesday, 11 March, 2014, 5:09am

Analysts have built entire careers analysing and re-analysing the mainland and its economy. They make predictions, get proven wrong and move on to the next topic.

It's been a very profitable pursuit, given that the so-called facts in much of the analysis are often completely divorced from reality.

The mainland's exchange rate policy is a case in point.

In the past decade, Beijing has been widely criticised for maintaining an exchange rate policy that severely undervalues the yuan. It is also universally agreed that that policy results from the mainland's mercantilist culture.

It is said that the reversal of the yuan's exchange rate in the past two weeks was an official attempt to punish speculators and stop a one-way bet on the yuan.

The mandarins in Beijing are portrayed as having a carefully thought-out and meticulously executed strategy on exchange rates.

They don't. And here's why.

The yuan's exchange rate - whether it is undervalued or overvalued - is the result of policy inaction, which is the government's habit of just muddling through.

The mandarins in Beijing work with whatever they happen to have and try very hard to maintain the status quo, whatever the consequences of that status quo.

Whatever the exchange rate happens to be, the Chinese officials tend to try to keep it where it is, even when it is very undervalued or very overvalued.

Suppose, when we wake up tomorrow, that the yuan is suddenly half its present value against the US dollar. Will the supposedly mercantilist Chinese government officials be happy?

No! They will see that rate as being too good and too favourable to the Chinese! They do not want something like that. They will want the old rate of six yuan to the dollar.

But if the yuan slowly moves towards five to the dollar, then five will become the appropriate rate as far as the Chinese government is concerned.

This odd state of affairs is a consequence of a series of historical accidents.

Those busy overanalysing the supposed shifts in the mainland's exchange rate policy do not understand this history. In the few decades until the early 2000s, Beijing had maintained an overvalued yuan.

When I started to work for the People's Bank of China in 1983, the yuan was officially fixed at two to the dollar, while the rate in the black market was between seven and eight yuan.

By the time I left the central bank six years later, the prevailing black-market rate had surged to 15 yuan.

The government had been determined to keep the yuan's official rate extremely overvalued, against the advice of the International Monetary Fund, the World Bank and others.

As a regulatory officer, I had participated in the central bank's work that began with monitoring and then clamping down on the black market.

A large number of officials and black marketeers were punished and even put behind bars for violation of foreign exchange controls. But the black market got bigger each year. So big, in fact, that the government had to introduce coupons to ration the limited amount of foreign exchange reserves. This was not officially abandoned for 16 years.

Partly to minimise corruption, the Chinese government devalued the yuan sharply, by as much as 30 per cent in one stroke, to 8.50 yuan to the dollar in 1991.

That move, coupled with several other factors, significantly boosted China's exports and reduced the scope for black marketeers over the next two decades.

The problem is that the devaluation was overdone, and the growth of China's foreign exchange reserves has got out of hand.

Today's analysts forget the consensus view on the mainland's exchange rate from the 1980s to the early 2000s.

Back then, the yuan was considered overvalued and set for imminent demise.

I was a contrarian voice in the 1990s when, as an analyst at HSBC, I declared that the yuan was undervalued and that China did not need to sell a dollar-denominated bond that HSBC and Goldman Sachs were underwriting. That wasn't what HSBC wanted to hear and I began working for UBS soon after.

So what is the lesson to be drawn from analysing the mainland's foreign exchange movements over the past 35 years? First, it is wrong to conclude that the mainland has a natural bias towards an undervalued yuan. Second, it is pointless to read too much into the supposed Chinese exchange rate policy.

When I was at the central bank, I never felt that there was a policy on the exchange rate, except to keep the status quo.

Policymakers in the real world have political, social and economic imperatives to deal with. Sometimes, they make policy based on gut instinct.

Analysts may say that some policies are "unsustainable", but they can be stretched for many more years - even for decades.

Just because an exchange rate severely deviates from the "fair rate" does not mean it will correct in the near term - not least because the definition of fair value is a fudge anyway.

Joe Zhang is the author of Inside China's Shadow Banking: The Next Subprime Crisis?


For unlimited access to:

SCMP.com SCMP Tablet Edition SCMP Mobile Edition 10-year news archive



This article is now closed to comments

‘Just because an exchange rate severely deviates from the “fair rate” does not mean it will correct in the near term – not least because the definition of fair value is a fudge anyway.’
If the exchange rate severely deviates from the “fair rate”, it’s not a stable equilibrium anymore --- like a small ball held inside one slant side of a bowl and let go.
Even given the yuan's more or less fixed nominal exchange rate vis-a-vis the US dollar, the real yuan exchange rate will have to correct anyway --- either now, by artificially raising or lowering the nominal exchange rate, or gradually, through adjustment in the real economy, by means of internal revaluation or internal devaluation.
The economy has to undergo either external adjustment or internal adjustment to go back to equilibrium (which of course is also changing).
Either internal stability or external stability has to be chosen, given a 'wrong' real exchange rate.
It may be argued that at present, since the Hong Kong dollar can't appreciate against the US dollar (as before 1997), thanks to the linked exchange rate mechanism, Hong Kong is now undergoing internal revaluation (as reflected by the refusing-to-drop-a-lot property market) to restore her equilibrium.
One way or the other, something has to give --- there is no escape.
Don't forget China's consumption expenditure, one of the components of China's aggregate demand.
One of the important reasons for a fall in the household income share of GDP comes from high personal income tax in China.
China has one of the highest income tax rates in the world, with tax rates ranging from 3% to 45%.
The government can consider lowering the tax rates on personal income tax, adjusting the tax brackets, introducing tax deductions, and levying additional taxes to balance out the loss of tax revenue from personal income tax reforms (like social security tax, inheritance and gift tax).
(From 'Strategic Priorities')
A lower interest rate can invigorate the stock market (the resulting wealth effect may help increase domestic consumption) and sustain the property market (which is now too big to fail and which takes time to slowly deflate).
It also helps the local governments, the SOEs and the SMEs to roll over their debts.
It’s said that a rolling debt gathers no loss, especially at lower interest rates.
In other words, interest rate liberalization, capital account relaxation, and yuan internationlization have to be deferred at present to buy time for other more important internal reforms (like debt deleveraging and further development of China's debt market).
Mend your own house first before you care about the external garden.
As is said in Kurosawa’s “Seven Samurai”, if your head is at risk, it’s foolish to care about your moustache.
The coming Asian Infrastructure Investment Bank, if successfully established, also creates demand to utilize some of China’s excess capacities (so does China’s increased military spending).
It’s said that, unlike US’s QEs (the Americans are deleveraging, hopefully, at very low interest rates), China’s current effort at deleveraging while the (market) interest rates are still very high (like those prevailing in China’s shadow banking system) is like having a surgery without anaesthetic.
One way out for China is to devalue (relatively massively) the yuan relative to the US dollar (keeping the exchange control as a necessary firewall).
The resulting stronger external demand will utilize some of the present excess capacities in China’s industries, and help sustain the employment level and the GDP growth rate.
It also releases some of the pressure on China’s investment expenditure needed to sustain the GDP growth.
Any potential massive capital flight out of China, which may cause a sudden rise in the market interest rate, can be tempered by the central bank’s relaxation of her monetary policy.
Joe’s arguments remind me of the title of one of Milton Friedman’s books: “The Tyranny of the Status Quo.”
To be fair, this kind of tyranny applies to many of the mandarins in various other economies as well, Hong Kong’s finance officials included.
I think China’s PBOC officials and the like know what they are doing, even though the central bank is not wholly independent (I think it’s under the State Council).



SCMP.com Account