Currency reforms won't be stalled by yuan volatility

The renminbi has experienced increasing volatility in recent weeks in light of new regulations and strong inflows that have seen the currency touch record highs versus the US dollar. This highlights the interesting challenge faced by Chinese policymakers – how to cool flows of “hot money” while at the same time pushing forward with much-needed reforms. As ever, it involves a tricky balancing act.

It is clear that hot money inflows have helped make the renminbi one of the bestperforming major currencies this year, at a time when growth in China is slowing. A further concern is that some of these inflows appear to be driven by appreciation expectations rather than real trade and foreign direct investment.

In response, the State Administration of Foreign Exchange announced a new regulation to curb currency speculation, effective from Saturday. The idea is to make foreign currency loans more expensive by requiring banks to set aside larger foreign exchange deposits against their loans.

This is an important step, as speculative corporate behaviour has become an increasingly important driver of foreign exchange flows in and out of China. Clamping down on these flows will lessen pressure on the renminbi in either direction.

The regulatory framework is tightening. But while inflow pressures may make authorities cautious, they are unlikely to bring the reform process to a halt. For example, the day after the new rule was announced, the State Council outlined nine measures to deepen economic reforms this year, including plans to unveil an operational blueprint by the end of the year for renminbi convertibility under the capital account.

Then, the State Administration of Foreign Exchange issued two circulars that simplify the process by which domestic companies may borrow renminbi or foreign currencies offshore, abolishing a number of regulations for inward FDI and overseas direct investment. The new framework is expected to make the administrative process more transparent. It underlines the official policy to push forward with foreign exchange reform.