MNI INTERVIEW2: China To Move Only Slowly On FX Liberalisation

The People’s Bank of China is unlikely to fully relinquish capital controls and foreign exchange intervention in the short term given a complex geopolitical landscape, a prominent economist and policy advisor told MNI, adding that its best approach for now would be to allow the yuan spot price to fluctuate within a wider band.

In an interview with MNI, Yu Yongding, who served on the PBOC’s monetary policy committee from 2004 to 2006, noted that the central bank has generally adopted a policy of “benign neglect” towards the yuan exchange rate against the US dollar in recent years. Rather than direct intervention by currency trading, the PBOC now takes a more subtle approach, adjusting reserve requirement ratios for foreign exchange deposits or the risk reserve ratio for forward FX sales, or else managing offshore yuan liquidity, or altering macro-prudential coefficients. (See MNI INTERVIEW: PBOC Should Be Flexible, Let Yuan Strengthen-Yu)

From 2019 until 2024, the PBOC had significantly reduced direct intervention, Yu noted, with China’s foreign exchange reserves increasing by USD94.5 billion up until the end of last year, compared with a USD770.3 decline billion from early 2015 to end 2018.

But the long evolution of China’s exchange rate regime from “managed float” to “free float” will depend on the further easing of capital controls, the development of capital markets, and the growth of hedging against exchange rate risks by corporates, he said. The exchange rate is no longer a central issue in China’s macroeconomic policy, he stressed, noting the central bank has not announced any change to the regime since 2017. 

In the first quarter of 2016, the central bank introduced a new mechanism for determining the daily central parity rate, based on the previous day’s close and with reference to a basket of currencies, a move which was intended to make the fixing price harder to predict in order to discourage speculation, Yu said.

In February, 2017, the PBOC also shortened the time window for calculating the currency basket index from 24 hours to 15 hours, and in May that year it further refined the pricing mechanism by introducing an “counter-cyclical factor,” granting it greater discretion in managing the exchange rate, he noted. 

Yu expects the current arrangements to be maintained, though he would prefer a wider band for volatility around the central parity rate than the current 2%.

PREVIOUS REFORMS

The economist argues that China’s two major exchange rate reforms since the move to make the yuan more convertible in 1994 would have yielded better results had authorities allowed markets a greater role in setting prices after the Asian financial crisis in 1997. 

In July 2005, the PBOC’s move to a managed float with reference to a currency basket was largely successful, though, according to Yu, authorities should have moved more quickly to depeg  from the U.S. currency, and the 0.3% volatility band permitted around the central dollar-yuan fixing was too narrow, with the result that hot money inflows inflated domestic asset prices, and made China accumulate too much foreign exchange reserves.

On Aug 11 2015, the PBOC announced it would allow market makers to set the daily central parity rate based on the previous day’s closing, and expanded the band around the central parity rate to 2%, but in the following three trading days, the yuan depreciated by about 4.66% against the dollar, forcing the central bank to step into the market. 

The ideas behind the reform were good, but the timing was not, Yu said. China's economy was then under strain, with both stock prices and property prices having seen heavy declines.

RESERVES SPENT

The PBOC spent about USD1 trillion of foreign exchange reserves to defend the yuan between Aug 13, 2015 and the end of 2016, abandoning its policy of basing the daily central parity rate on the previous day’s closing. Yu argues that the currency should have been able to withstand a significant depreciation pressure in 2015, considering China’s ability to manage cross-border capital flows and its huge trade surplus.

Towards the end of 2016 and in early 2017,  the dollar index began to retreat, and even countries which had made no efforts to intervene despite steep depreciations saw their exchange rates stabilise and recover, he added.