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China’s instinct is to control, not devalue

First published: 12th February 2016

I’m quite aware I could be giving a hostage to fortune here, but I don’t think China will devalue the Renminbi (RMB) in ways that people think it will be forced or choose to. Instead, and if pushed by the capital flight that’s bleeding its reserves, China’s basic instinct will be to carry on tightening capital controls, and punishing those that try to breach them. Here’s why.

China’s remarkable integration into the world economic system over the last 25 years is running up against a rising tide of economic and financial problems, as is well-known. January’s drop of $100 billion in currency reserves in January symbolises the country’s immersion in a policy conundrum, known as the ‘impossible trinity’. It can only be resolved in two ways: by means of a devaluation of the RMB or by tighter capital controls. Each will have far-reaching consequences. A devaluation that’s big enough to make a difference would trigger a major deflationary shock into the global system that could precipitate the recession we all fear, while throwing China’s economic rebalancing challenge into reverse. Tighter capital controls would be in keeping with China’s historic suspicion of excessive foreign influence – in this case towards liberalisation – and support those who have been lukewarm or opposed to significant economic reforms anyway.

The impossible trinity, framed originally by the Nobel prize-winning economist, Robert Mundell, in the late 1960s, is about the pursuit of incompatible objectives. Simply, it is impossible to pursue more than two of an independent monetary policy, a fixed exchange rate, and free capital movements simultaneously. China’s trilemma is that it trying to realise all three goals, and something has to give.

There is no question China wants an autonomous monetary policy. The problem has emerged in trying to bolt on incremental financial liberalisation, including of capital movements, and the exchange rate system, partly to support the admission of the RMB to the IMF’s Special Drawing Right last year. Yet financial liberalisation has become increasingly at odds with the sharp slowdown in economic growth and the relentless surge in debt accumulation.

The point at which China has to choose its RMB and capital regime trade-off is approaching fast. If China persisted with capital liberalisation, it would have to allow the RMB to devalue sharply or float freely. But a small devaluation would barely offset recent Chinese wage gains, while encouraging expectations of further depreciation. A shock devaluation of, say, 40 percent or more, would be politically dangerous, and, as already noted, the exact antithesis of what economic rebalancing requires because it would represent a tax on the household sector as imports became more expensive, and a subsidy to producers and exporters.

The alternative, in which priority would be given to keeping the RMB relatively stable, would entail tighter controls over foreign currency transactions, about 80% of which are fully or partly convertible, according to the IMF. Here is the IMF paper  and here is one bank’s estimates for China based on it.

Tighter controls alone would not necessarily help economic rebalancing and debt management, but are likely to be politically more acceptable. Indeed, in recent weeks, China’s penchant for control has been evident. Checks and controls over foreign exchange transactions have been tightened. Banks have been subject to new currency trading restrictions, and greater scrutiny extending to punishment is being exercised over outward capital transactions.

The immediate issue is the relentless decline in China’s foreign currency reserves, which have now fallen from a peak of $3.9 trillion in 2014 to stand at $3.2 trillion. Whether these are adequate depends on how far China blends exchange rate flexibility with free capital flows. With a relatively fixed exchange rate and tighter capital controls, China’s reserves would need to be about $1.68 trillion. With the former but no controls, China’s reserves are only $400 billion away from the minimum prudential level.

If China floated its currency, the IMF reckons China would need about $1.5 trillion without any controls, and $1.14 trillion with them. Clearly, these are extremes, and China is betwixt and between with a relatively fixed exchange rate and a mixed, but porous system of controls.

Yet on current policies, it is hard to see how China could stem capital flight for long. Chinese companies and citizens have become much less sure about the stability of the RMB because of the sustained decline in economic growth, investment returns, and profits  and looser monetary policy. The government’s rhetoric about the growing significance of the RMB in global finance at the US dollar’s expense, the mini-devaluation in August 2015, and the adoption of a reference basket comprising 13 currencies in December have also undermined what was high public confidence in the US dollar link.

Capital exports, excluding foreign direct investment overseas, have been rising, reaching about $800 billion in 2015. Companies have been over-invoicing exports as a way of moving capital away from the Mainland, while banks, companies and citizens have shifted capital offshore, fueled by rapid growth in broad money and credit. China’s reserves as a proportion of the money stock, for example, amount to just 15.5%, half the ratio in 2007-08.

Western economic thinking recognises China’s trilemma, but insists that openness, freer markets and liberalisation are the way forward. Several hedge funds are reported to have taken positions based on a future, large devaluation. But these ideas, centred around the removal of direct interference in markets and a major change in regulatory and ownership policies, are easier to propagate in Washington DC or London, than to accept in Beijing. They are, after all, code for a shift away from the primacy of the Communist Party to global and private markets. We should remember that the Party’s raison d’etre is to be in power and exercise control. If global markets and reforms are seen as a threat, China’s basic instinct is to impose controls, and shelve or roll-back financial and other reforms.  This seems the most probable outcome in the first instance, whether or not a larger exchange rate shift follows later.