Since 1978, China has engaged in an unprecedented and wildly successful experiment, moving gradually from a command economy to one based on markets; in small steps transforming a system where administrators controlled the goods that were produced to one where prices allocate resources. There were surely miscalculations along the way. But, even big blunders could largely be concealed. Until now!
What has changed in recent months? The day has come for China to become more closely integrated into the global financial system, and this has a number of implications. The most important is that as prices and quantities of financial assets (rather than goods) are determined in markets, bureaucrats lose a great deal of control. But, as recent events very clearly demonstrate, Chinese authorities are reluctant to let go.
Last August, we posted our most popular blog piece to date: China’s Capital Controls and the Exchange Rate Regime. In it, we explained how capital controls make it possible for China to maintain a fixed exchange rate while policymakers could adjust interest rates to stabilize their domestic economy. We also highlighted how these same capital controls are incompatible with the objectives of making Shanghai a global financial center and the renminbi (RMB) a leading international currency. Given the risks inherent in freeing cross-border capital flows, we concluded that the process of financial liberalization (both domestically and externally) would remain gradual. Yet, having seen China develop in unprecedented ways in the past, we have been watching to see if China could also alter conventional paradigms of finance and monetary policy. Could China do what no one else has done?
Well, it turns out that the “impossible trinity” or “trilemma” – which compels policymakers to choose only two of three from among free capital flows, discretionary monetary policy, and a fixed exchange rate – may be more like a physical law than nearly any economic principle we know. And policymakers in China look to be quite unhappy about the constraints this is creating. (For more on the impossible trinity, see here and here.)
Here’s what has happened. In an effort to promote RMB internationalization, policymakers have been liberalizing domestic interest rates and easing obstacles to cross-border capital flows. At the same time, growth has been slowing. So, to support a flagging economy, the central bank cut policy interest rates and reserve requirements in a series of small steps. This mix of more porous capital controls and easier monetary policy has generated the expectation of a currency depreciation. So, investors have sold RMB at the fixed exchange rate to the central bank in exchange for hundreds of billions of U.S. dollars, resulting in an unprecedented decline of foreign exchange reserves (see figure 1). More recently, unhappy with the plunge in equity prices, the authorities have employed a raft of anti-market policies aimed at controlling volatility. While these actions have had significant financial costs, their most important consequence has been to damage policy credibility, discourage investing in China, and (probably) trigger greater capital outflows, too.
Figure 1. China's total reserves excluding gold (trillions of U.S. dollars), 1995-July 2015
Sources: IMF International Financial Statistics and Bloomberg survey.
It is against this uneasy backdrop that China officially devalued the RMB on August 11. Policymakers have advertised this shift as a move to foster a greater market role in determining the value of the exchange rate. Yet, they have allowed the RMB to edge lower by just 3%, a mere blip compared to the 30% nominal appreciation since China began revaluing the RMB in 2005. More important from an economic and trade perspective, in real trade-weighted terms China’s currency remains about 10% higher than a year ago, and 55% higher than 10 years ago (see figure 2).
Figure 2. Yuan/U.S. doilar exchange rate and China's real effective exchange rate (Jan 2005=100), 2005-Aug 2015
Sources: FRED, BIS, and authors's projection.
This odd and contradictory policy mix has unsettled financial markets at the same time that it leaves China’s exchange rate regime in a kind of half-way house. Were Chinese policymakers willing to simply float the RMB today, it could easily sink by 10% on a trade-weighted basis and – in light of the tendency of other Asian currencies to move with the RMB – it could fall by significantly more against the U.S. dollar. If, instead, the authorities wish to steady the RMB/U.S. dollar exchange rate, then the additional monetary policy easing needed to support the economy is likely to accelerate the decline of foreign exchange reserves.
Unsurprisingly, investors appear to expect some mix of both. Having already fallen by $350 billion from the peak of $4 trillion in June 2014, market participants expect a further $200-billion-dollar drop of reserves over the remainder of this year (see figure 1). Because China’s reserves are so massive, the central bank might be able to sustain this process for years. However, the sudden jump of short-term Hong Kong RMB interest rates following the August 11 devaluation highlights the compensation that investors are now demanding for taking on additional RMB downside risk, so the pace of reserve decline could accelerate.
This combination of anticipated devaluation and lingering obstacles to short-term capital flows is re-shaping the constellation of onshore and offshore interest rates. As Figure 3 shows, likely reflecting a preference for the freedom afforded by offshore accounts, Hong Kong RMB deposit rates are usually lower than Shanghai rates. Until March of this year, capital controls meant that the two markets were highly segmented, so that daily interest rate changes between Hong Kong and Shanghai were largely uncorrelated. The narrowing of the spread and the increased co-movement of these rates beginning in March 2015 signaled greater influence of cross-border arbitrage leading to closer market integration (see our previous analysis here.)
Between May and July these short-term money markets were fairly steady, with the Shanghai rate averaging 33 basis points above the Hong Kong rate. However, since the August 11 devaluation, the spread has reversed, with the Hong Kong deposit rate higher by between 30 and 425 basis points. Our interpretation is that Hong Kong investors are now insisting on compensation for RMB devaluation risk that Shanghai investors cannot yet obtain.
Figure 3. China RMB three-month deposit rates: onshore (CNY) and offshore (CNH), 2013-27 Aug 2015
Source: Bloomberg indexes CCDRC (CNY) and CGDRC (CNH).
Like the RMB, domestic equities are also stuck in a messy half-way house that reflects policymakers’ discomfort with the inconvenient dictums of market forces. If the currency regime is now best characterized as an “adjustable peg,” the equity market might be called a “dirty float.” But, even supposing this is tenable for an exchange rate, can it work for stocks?
While the authorities appeared to have been delighted by rising equity valuations – even when driven to unsustainable levels by uninformed retail investors buying on leverage – they exhibit little tolerance for the flipside of the price system. Yet, much to their discontent, investors have reconfirmed that when it comes to equity markets China is not immune from the economic and psychological forces at work in the rest of the world. That is, asset price stability is inevitably inconsistent with the fundamental volatility of equity markets; and a one-sided policy tilt that encourages prices to go up but prevents them from going down is simply counterproductive.
Indeed, recent official interventions have damaged confidence in market integrity. Will potential future buyers ignore the loss of liquidity that results when equity trading is halted or, worse, when the government threatens to criminalize sales? Will indebted firms turn to equity finance knowing that issuance will be halted at official convenience? Will investors break the habit of pricing equities based on government preferences rather than firm fundamentals?
To be sure, domestic equity prices have plummeted, but given official actions, one has to wonder if we don’t have significantly further to go (see our earlier commentary about the equity boom here). As of August 28, the Shanghai (Shenzhen) composite index has plunged by 38% (46%) from the June 12 peak. Price-to-earnings ratios also have fallen. However, equity prices are still up by 46% (52%) from a year ago. Similarly, while margin loans have roughly halved from the June peak, at ¥1.1 trillion they remain more than double the year-ago level. Finally, the onshore equity price premium for a sample of firms that are traded on both the Shanghai and Hong Kong (Hang Seng) markets is more than 30%, compared to a discount of nearly 10% a year ago. As a result, we suspect that there are still millions of new, inexperienced account holders in China who are at risk of margin calls if equity prices slide again.
This all brings us back to the August 11 devaluation. How should we interpret this? By itself, a devaluation of just 3% serves no purpose. Everyone knows that on its own it will have little impact on net exports and growth, so that can’t be the explanation. If the purpose was to stem the tide of capital outflows as the central bank lowers interest rates, the mini-scale of the August 11 devaluation could easily backfire because it is too small to create expectations of a future currency appreciation. Instead, like the old potato chip commercial (“bet you can’t eat just one”), it fosters expectations of further depreciation, motivating further outflows. Perhaps the authorities anticipate a series of small devaluations that become cumulatively meaningful, but that policy course would have its own complications (including intensified conflict over global trade).
For a country that wishes its currency to join the ranks of the reserve currencies, the reputational costs of a modest devaluation would seem to sharply exceed any possible economic benefits. Ultimately, a true reserve currency is one that is reliably available to provide liquidity insurance internationally even in tough times. As our friend and colleague William Silber notes in his book on the financial upheavals that accompanied World War I, this is one reason staying on the gold standard propelled the U.S. dollar to the reserve status it still maintains today. Imagine, instead, that American officials in 1914 had chosen to leave the gold standard in order to achieve a depreciation of 3%!
The Chinese authorities’ newly demonstrated lack of confidence in financial markets – whether the RMB or equities – undermines their promise to increase reliance on market forces. So, while the IMF welcomed the RMB “regime shift,” no one anticipates a floating currency regime anytime soon. Similarly, the government’s clumsy equity market interventions have encouraged investors to push back the expected timing for including China’s domestic equities in key international benchmarks, and at least temporarily dampened hopes for Shanghai to become an international financial center. But, without a system in which foreign exchange and equity prices are market determined, global integration of China’s financial system as well as reserve status for its currency will remain beyond the country’s grasp.
The bottom line: Today, China is the world’s largest economy on a purchasing-power parity basis. And it still has the second largest equity market (by trading volume and capitalization). If and when market forces clearly become the dominant factor in currency and equity price determination, the RMB and China’s financial assets will gain sharply in global importance, as will China’s domestic financial markets. Yet, by this standard, China’s 3% devaluation is no game changer. If anything, the recent actions by the government have delayed its achievement of these aims.