A Few Words on China’s “New” Exchange Rate Regime

China seems to have modified its exchange rate regime once again. The daily fix no longer needs to reflect the previous day's market close quite as closely. Keith Bradsher of the New York Times:

“On Friday the government said it was considering introducing a 'counter-cyclical variable.' A better name might be 'fudge factor.' It means the government would no longer have to follow the previous day's closing price in setting the day’s benchmark.”

When the policy was announced last Friday, I thought the "X" (fudge) factor might be used to give weight to keeping the yuan stable against the dollar—in effect, formalizing the policy rule the PBOC seemed to have been following earlier this year. In practice, at least this week, it has been used to guide the yuan up against the dollar (with up meaning economically stronger, not numerically higher).

So far, though, the appreciation against the dollar hasn't done more than offset the downward drift in the yuan's value against the basket that occurred earlier this year as the dollar generally depreciated. The dollar's "Trump" rally has more or less been reversed—and the yuan is technically still a bit weaker against the basket than it was in late October. In other words, it isn't yet clear if China is just trying to remind the market of two-way risk by letting the yuan rise a bit against the dollar, or if it is now wants to reverse some of last year's depreciation against both the basket and the dollar.

I at least do not think that the explicit reintroduction of discretion in how the daily fix is set tells you how China plans to manage its currency going forward so much as signals that China still plans to manage its currency, and wants to be able to use the fix—not just spot intervention—to guide the market.

The reality, in my view, is that the PBOC’s August 2015 reform never quite worked. Not in a technical sense.

Up until then the PBOC had used the “daily” fix to guide the market. Officially, of course, the fix wasn’t set by the PBOC. But in practice, of course, it was. Changes in the fix helped set the market's expectations.* At various points in time the spot exchange rate was allowed to diverge a bit from the fix—but mechanically, it couldn’t diverge by too much.  The band also tended not to work, as the yuan was typically at one end or the other of the band, or would have been but for intervention.

The August reforms, among other things, sought to close the gap between the fix and the spot. The previous day's close, together with moves in the yuan against a basket of currencies, would determine the setting of the fix the next day.

Voila—the exchange would soon, in theory, be market-determined. 

But the August reform was combined with an initial depreciation of the fix. It was interpreted, I think correctly, as a signal that China wanted a weaker currency (see this Reuters story). Carry trades—borrowing dollars to buy yuan to collect the interest rate differential on the assumption the yuan would be stable against the dollar—unwound violently. Chinese corporations expected the yuan to depreciate and started to hoard dollars. The spot kept pulling the fix toward a depreciated level.    

Neither China nor the world was ready for China to float at that time. Especially as it quickly became clear that a float would mean a big, sudden move down.

The solution: simple: the PBOC and its agents intervened in the market to limit depreciation. That way the close in the spot market didn’t keep pulling the fix down.

Basically, in an effort to make the yuan more market determined (or, if you are cynical, in an effort to make a depreciation against the dollar stem from market pressure rather than from a conscious decision to guide the yuan down through a set of weaker fixes) the PBOC reduced the utility of one of its standard tools of exchange rate management (the signal from the setting of the fix) and in the process increased its reliance on direct intervention in the market (e.g. selling reserves to limit the pace of depreciation).

As I have noted in the past, China never really stopped managing its exchange rate. In 2015, the yuan was first managed for stability against the dollar, and then managed to limit the pace of depreciation against the dollar. China then managed its currency to depreciate against a basket (by responding asymmetrically to dollar moves) in the first half of 2016 and for stability against the basket in the second half of 2016. And this year, at least until the past week, it has seemed more and more as though China was looking to keep the yuan stable against the dollar rather than against the basket.

I consequently am not totally surprised that China once again wants to use the fix as an independent policy tool.  

But the basic issues around China’s currency in my view remain. Is China basically happy with the current level of the yuan against both the basket and against the dollar? Would China follow the dollar up if the dollar reverses its recent course and starts to appreciate again? Or would it depreciate against the dollar if the dollar strengthened, even if that meant weakening through 7 yuan per dollar?

I personally am not terribly bothered by the fact that China is likely to continue to manage its currency for the next few years, even if that creates a gap between China's monetary and exchange rate policies and the policies of the other major (SDR basket) economies.** In fact, I would be more worried if China stopped managing its currency and the yuan dropped significantly, adding to China's already considerable trade surplus. I would welcome a period where China manages its currency to keep it relatively stable if that stability gives China time to do a serious recapitalization of its domestic financial system and to make serious reforms to its social safety net.  

But turning a blind eye to something that may (or may not) end up looking like a repeg to the dollar at more or less the same level as in 2008 also isn’t without risk to the global economy. If China scales back on its current stimulus too aggressively—both by curbing the growth of credit through prudential policies and in effect engaging in fiscal tightening by limiting off balance sheet fiscal stimulus from local governments—with a constant exchange rate, China’s external surplus could rise.*** 

The win-win takes more than exchange rate reform, or, if you prefer, a reversal of exchange reform. It requires policies that would bring down China's still very high saving rate—and in the process allow China to tackle its internal imbalances without running the risk of returning to a large external surplus.

* The pace of China's 2005 to 2013 appreciation against the dollar was almost entirely determined by changes in the fix. Spot never diverged much. China didn't want the market to pull the yuan up too fast (it was a different time, and the dollar was at a different level against the other big currencies).

** The other currencies in the SDR float against each other, with independent central banks that conduct monetary policy aimed at meeting domestic policy goals. China lacks an independent central bank, and manages its monetary policy in part to achieve an external objective (a basically stable exchange rate). I personally think China retains, thanks to its Chinese characteristics, more monetary autonomy that would normally be expected for a country with a more or less fixed exchange rate. 

*** In theory a rise in China’s trade surplus might be offset by a fall in the surpluses of the eurozone, Japan, Korea, and Taiwan, but I worry that in practice it is more likely to result in a bigger U.S.—and North American—trade deficit.