China’s ongoing FX trilemma and its possible consequences

From UBS’s Tao Wang on what, post China’s surprise revaluation, is now an oft used phrase, the impossible trinity — AKA the corner China finds itself in:

The impossible trinity says that a country cannot simultaneously have an open capital account, independent monetary policy, and stable tightly managed exchange rate. Some academics (such as Hélène Rey) argue that since capital controls are no longer as effective in the current day world, complete monetary policy independence is still not possible without some degree of exchange rate flexibility, even without a fully open capital account – or impossibly duality.

Regardless of whether it is an impossible trinity or duality, the fact is that in recent years, as a result of substantial capital controls relaxation, China has found it increasingly difficult to manage independent monetary policy while simultaneously maintaining a fixed exchange rate. Since last year, the PBC has had to repeatedly inject liquidity and use the RRR to offset capital outflows – its efforts to ease monetary policy have been less effective because of FX leakages, while at the same time rate cuts are reducing arbitrage opportunities to add further downward pressures on the currency (Figure 15). As China’s government has announced and seems to be committed to fully opening the capital account soon, these challenges will only become greater. Therefore, it is the right thing to do to break the RMB’s dollar peg and move to materially increase its flexibility.

At the moment, China’s weak domestic demand and deflationary pressures necessitate further interest rate cuts, which may further fan capital outflows and depreciation pressures. Meanwhile, not only is the RMB’s recent effective appreciation still hurting China’s tradable goods sector, but the central bank’s defence of the exchange rate is also draining substantial domestic liquidity that necessitates constant replenishing, both of which is undermining the effectiveness of overall monetary policy easing.

With a more flexible exchange rate, the RMB can be weakened by outflows and depreciation pressures without draining domestic liquidity, and domestic assets will become relatively cheaper and thus more attractive than foreign assets – which may ultimately alter market expectations to reduce capital outflows. In addition, a weaker RMB should improve China’s current account balance to also alleviate depreciation pressures. Conversely, if China’s exchange rate is allowed to appreciate along with capital inflows and appreciation pressures, it will make domestic assets more expensive and less attractive, to ultimately worsen China’s current account balance.

But, everything has consequences, TANSTAAFL etc…

And one of those, considering the trilemma, is that China might have to backtrack on its moves to open capital controls. Particularly as SDR inclusion has been pushed back.

As Citi said before — while discussing the adequacy, or otherwise, of China’s reserves — “if there are controls in place which inhibit outflows, then fewer reserves are needed…but since China is in a process of dismantling capital controls, the effective ‘cushion’ that is created by the presence of controls will weaken over time. ” Which is fair.

In China’s defence though, what’s also fair is that “the need for plentiful reserves should be reduced over time by the RMB’s emergence as an international reserve asset – a path on which SDR inclusion will be an important milestone. Put simply: once a country can print a currency which is internationally accepted as a store of value, then its need for precautionary holdings of other countries’ reserve currencies will fall.”

But, as we noted, when quoting them the first time, SDR inclusion is now delayed and we wonder if that means the capital controls position will have to change? Perchance to do so now officially will be too embarrassing? Perchance they might start by coming down harder on unofficial channels?

We shall see, do keep an eye on China’s underground system, you know, like “ants moving houses”, Macau and other such outlets.

Back to TW:

For either capital account or current account channels to work to give monetary policy sufficient room to cater towards domestic need, the exchange rate has to be sufficiently flexible and market forces must be allowed to play a sufficient role.

But will the Chinese government allow the exchange rate to move sufficiently? If the market believes the RMB needs to depreciate by 10% and the government intervenes to stop it, expectations will only worsen. Will the PBC then sacrifice its interest rate and monetary policy independence to stabilize the exchange rate, or vice versa? If the former, then the whole purpose of China’s exchange rate move – being greater interest rate and liquidity policy independence – is lost. It is also not wise for a large economy to give up its monetary policy independence, given the different issues and economic cycles it will have to face as a result of upcoming changes in the US. If the later, then domestic political pressure from groups with large FX exposures will likely increase; as global pressure and trade protectionism against Chinese products likely rise too. In addition, the internationalization of RMB may suffer a nominal set back as fewer people would want to hold RMB assets, causing offshore RMB deposits to decline.

If the government wants to maintain both relative stability of the exchange rate and monetary independence, realistically it cannot do so without capital controls. Its recent RMB move has made this painfully clear – since August 11, the central bank has spent more than $100 billion trying to prevent further RMB depreciation (Figure 16), according to market estimates. At this pace, even China’s $3.7 trillion in FX reserves will not last that long before confidence weakens further and domestic political pressures rise as a result of heavy losses in the country’s reserves. In addition, selling large amounts of China’s FX holdings and US or other government papers could also raise international concerns.

The dilemma faced by China’s government is clear. Assuming that China wants to preserve monetary policy independence, it has to either let the exchange rate adjust more freely and substantially, or use the capital controls it has by tightening them. The latter could include seeing through the proper implementation of documentation requirements supporting FX purchases (which have relaxed in the last couple of years), tightening risk controls on corporates, and placing reserve requirements on FX holdings. However, tightening capital controls goes against the government’s stated objective of full capital account convertibility and RMB internationalization ambitions, and could also invite criticism or accusations that China is backtracking on reforms. That said, in our view, neither is using the so-called “market-based intervention” – spending reserves to defend the exchange rate at overvalued levels against market pressure – really a viable solution.

Given this dilemma, while in the midst of dealing with a protracted economic slowdown driven by an ongoing property downturn and high leverage levels, it is not surprising why many China watchers and investors are puzzled by the government’s continued pursuit of capital account opening.

Fwiw, TW is betting on more depreciation and tightening of existing capital controls — that’s not exactly what she thinks they SHOULD do, of course, but constraints are constraints even for China:

What path will China’s policymakers take in the coming months? Given that the real economy still faces persistent downward pressures, corporates are struggling with a very high debt burden and still very high real interest rates in a deflationary environment, and exports continue to suffer from the past couple of years’ of RMB appreciation, we think China should ease monetary conditions further and let its exchange rate depreciate more substantially. To stabilize expectations and avoid too much overshooting and volatility, the Chinese government should depreciate the exchange rate quickly and unexpectedly before increasing the flexibility of the exchange rate, and at the same time tighten capital controls.

However, given the aforementioned trade-offs in its policy options and the Chinese government’s desire to maintain exchange rate stability while pursuing internationalization-related reforms, we think the more likely outcome would be that the PBC continues to defend the RMB for a while using FX reserves, before resorting to tightening existing controls and slowing further capital account opening. This may not prove to be very effective as the exchange rate has not been allowed to adjust sufficiently. Sometime next year we could see RMB being allowed to depreciate by another 3-5% depreciation against the USD, which if not managed well could serve to further entrench depreciation expectations.

Based on the above analysis, we maintain our end year USDCNY forecast of 6.5, but revise our end-2016 forecast from 6.6 to 6.8, and see FX reserves falling by more than $500 billion by then. As a result, we expect the PBC to further cut the RRR in the rest of 2015 and in 2016 (by at least 250-300bp if no other liquidity tools are used), while also using other liquidity facilities to ensure accommodative monetary conditions in China.

Related links:
This isn’t the Chinese capital account liberalisation you’re looking for – FT Alphaville
Questioning China’s reserves with Charlene Chu — BI
China’s holy trinity and the need for RMB stability – FT Alphaville

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