How China can best solve its currency crisis

China’s crawling currency peg is in a slow-motion crisis. Softening economic growth and the downward creep of the yuan have become a self-feeding prophecy, leading more and more households and businesses to convert their domestic savings into dollars. Currently, the People’s Bank of China (PBOC) still holds US$3.3 trillion in foreign exchange reserves, a formidable war chest to defend the currency. However, at the current rate of capital flight (about US$150 billion a month), China’s official reserves could dip below the levels that are deemed “adequate” by the International Monetary Fund, or even halved by the end of the year. Simply put, the current strategy of defending the peg is not sustainable.

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What should the central bank do? The PBOC is faced with the so-called “impossible trinity” – with capital account mobility, a central bank can either control interest rates or foreign exchange rates, but not both. Practically, therefore, the central bank has three options to deal with its currency market problem:

●The first is to reimpose or tighten capital controls, which would allow the central bank to drop interest rates and reserve requirements to stimulate the economy, while keeping the currency peg.

●The second option is to simply float the yuan, letting market forces find the new equilibrium for the currency market.

●The third option is to sharply increase fiscal stimulus to the point where the expectations of falling economic growth and yuan depreciation are effectively reversed.

Each option has its own unique set of economic, social and political benefits and costs. Reimposing capital controls is easy and quick to implement, and may produce an instantaneous effect on reducing capital flight, but would entail many side effects in the longer run. For one, it is an anti-market move that would mark a major step back from China’s long-term goal of financial market liberalisation. It would also mark a major setback for the yuan to achieve full convertibility, which is essential for the currency to truly become a global reserve currency.

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More importantly, restricting capital flows would guarantee dual pricing, with official foreign exchange rates living hand in hand with “black market” rates. This would lead to chaos and turmoil in the financial system down the road.