Has Beijing learnt the right lesson from its yuan mess two years ago?
Despite its long-term goal of a free-floating currency, the central bank’s continued interventions suggest that this is currently seen as far too risky
The situation of the Chinese currency could not be better these days.
Two years after the People’s Bank of China shook global markets with its abrupt 1.9 per cent devaluation of the yuan, the currency is now strengthening steadily against the dollar and China’s foreign exchange reserves have been rising for six months in a row.
The Chinese economy, which grew by 6.9 per cent in the first half of 2017, and the yuan are no longer seen as sources of risk for the global economy.
In contrast to the moment in September 2015, when the Federal Reserve had cited China as a reason for its decision to hold off an anticipated interest rate increase, investment banks and international agencies in the last months have been busily raising their forecasts for Chinese growth and the value of the yuan.
There are signs that money is flowing into China at an accelerating pace. Foreign holdings of Chinese assets rose 16 per cent in the second quarter of this year, or the second-highest quarterly rise, as foreign appetite for Chinese stocks and bonds “improved materially”, according to the latest report from Standard Chartered.
At the same time, there are still questions over whether Beijing is trading its long-term goal of building up a properly functioning market system, in which a market-based exchange rate will be a vital part, for tactical victories against the “China bears” in the market and the immediate results of market stability.
Beijing was blamed for a lack of transparency and blatant market intervention in tweaking the yuan two years ago. Now the Chinese authorities have opted for capital account controls and a mysterious “counter cyclical” factor in deciding the yuan value, walking further away from their stated strategic goal of an open capital account and a freely floating exchange rate.
“It’s getting further away from the goals [of free floating], especially after the counter cyclical factor was added into the daily fixing formula in May,” said Zhang Ming, a senior researcher with the Chinese Academy of Social Sciences. The yuan regime has “become less transparent and the [role of] supply and demand was weakened” in setting the yuan’s value.
While the weakening US dollar has helped the yuan to appreciate to the highest level since October 2016, Zhang said the bigger power of the central bank in influencing the yuan rate was also a factor.
“The intervention has been enhanced, rather than weakened,” he said.
China’s process of building up a market-based exchange rate is only halfway done. The central bank will publish a mid-point price every trading day, and the yuan will be traded against the dollar within a 2 per cent band.
While China is the world’s second biggest economy and the world’s biggest commodity trading country, it is still relatively troublesome for funds to enter or leave the country.
China has launched only a few channels – ranging from the Qualified Foreign Institutional Investor scheme, launched in early 2000s, to the bond connect programme, which started operation only last month – for foreign investors to access onshore bonds and stocks.
The control over outbound remittance and payment has been tightened. Every Chinese citizen is entitled to use foreign currency within an annual quota of US$50,000, and overseas investments by Chinese businesses face strict scrutiny.
The fear of financial turmoil still trumps Beijing’s desire for a global currency or a “clean float” system, according to Xie Yaxuan, chief macro analyst of China Merchants Securities.
Even though a free floating currency is almost a default choice for the world’s major economies, it is still viewed in China as a source of risks, Xie said.
Beijing has abandoned an approach of “leaping forward” to embrace a “conservative therapy” in its yuan mechanism, he said. “China can’t skip the learning process,” Xie added.
Compared with the euro, the yen or the sterling’s movements against the US dollar, the yuan’s volatility is limited. The yuan had once approached a key psychological level of 1:7 against the greenback at its weakest point but never really broke the level.
China’s banks and companies are not yet used to big swings in exchange rates.
A foreign exchange strategist with a foreign bank in China, who declined to be named as he is not authorised to discuss the bank’s business to media, said August 11 2015 [the date of the yuan devaluation] left no fond memories for him as many of his bank’s clients panicked.
“Nearly all of them worried about a fast yuan depreciation and thus scrambled for US dollar,” he said.
A stable yuan, meanwhile, has served the Chinese economy well over the past two years.
But it may not be the case looking ahead.
“China’s policymakers clearly value economic stability,” Joseph Gagnon, a senior fellow of the Peterson Institute for International Economics, told a joint session of the central bank and the International Monetary Fund at the end of April this year.
“However, a stable exchange rate...will not deliver stability in China’s external balance, which is fundamentally more important,” Gagnon was quoted in IMF memos released last month.