How the Yuan Crisis Could Forge a New Currency Order



The pace of decline in China's external currency reserves is accelerating, feeding panicky selling of the yuan and heralding a likely change in China's exchange rate arrangements. Exchange rate pressures in China are spilling over to regional currencies and global stock markets. In January alone, China lost $99.5 billion of its dollar reserves trying to keep the yuan in its 2.0 percent official fluctuation band around 6.5419 to the dollar. In just 15 months the Chinese have lost more than $650 billion in reserves, more than the total reserves of any other country save Japan. In between massive interventions, the government has tried to stem pressure through small devaluations and increasing the costs for those shorting the yuan. This isn't just another emerging-market currency crisis: China is the second largest economy in the world, and its response to this fire could forge the beginnings of a new currency order.

The market unrest has puzzled many. China's reserves are still over $3 trillion, and they dwarf short-term external debt, which is approximately $625 billion. The slowdown in the Chinese economy was well flagged. I suspect the shattering of the market's previous confidence that the Chinese government was omnipotent in matters such as exchange rates has played an intangible but powerful role in increasing risk aversion by Chinese corporates and residents.

For 20 years I made a decent living in foreign exchange dealing rooms. My experience is that in these risk-averse environments, selling is not confined to the normal metrics of potential currency pressure such as short-term external debt or worsening trade positions. The selling spreads to local corporates and residents. They only have to try to switch a small part of their stock of domestic assets into foreign currency for any level of reserves to be overwhelmed. Selling pressure from locals is often insufficiently considered, especially as they are adept at finding ways to sell local currency beneath official restrictions. I recall Bertie Ahern, then Ireland's finance minister, excitedly threatening to name and shame US hedge funds that had sold the punt ahead of the February 1993 devaluation. Later, tucked away in the back pages of the Irish Times I saw a list of sellers that was dominated by local corporates.

Rightly or wrongly, I suspect Chinese officials will be persuaded that the only way to alleviate the pressure on external reserves and hence domestic liquidity is to change the exchange rate regime. The objective of any change will be to reestablish "two-way" markets of buyers and sellers. Officials are therefore likely to be furiously debating sticking to narrow bands but devaluing to a super-competitive rate, or switching to a free float, or something in between.

Narrow bands invite speculation. When an exchange rate is on the weak side, the central bank buys local currency from the speculator at a higher rate than anyone else, and if the speculation fails to lower the local currency, the bank limits the speculators' losses by offering to sell local currency at the other side of the narrow band. But policymakers in highly open economies also have a well-developed fear of floating. They observe wild swings in sentiment and believe large exchange rate shifts easily become self-fulfilling prophecies: Depreciation begets inflation, which begets depreciation. In the current frenzied situation a free float could easily lead to the yuan crashing through 8.50 versus the dollar. That could turn a currency crisis into a political and trade crisis before the currency has a chance to bounce.

In my experience the holy grail of foreign exchange rate arrangements is one that offers both guidance to the market and flexibility like John Williamson's idea of target zones. The closest I have seen to this in real life was the adoption of extra wide fluctuation bands within the European Exchange Rate Mechanism between 1993 to 1999. The +/-15 percent bands served to reduce currency speculation long before expectations took hold that the Economic and Monetary Union would become a reality. Under the wide bands the risk of speculation going wrong was no longer the cost of the exchange rate bouncing from one end of a tiny band to the next, but moving as much as 30 percent the wrong way. Consequently, as one set of speculators pushed a currency to one end of the band, another set of speculators began marching the other way.

China should stick to the central parity of 6.54 that appears to be competitive, but express it in terms of a neutral currency basket like the International Monetary Fund's special drawing rights and widen the fluctuation band to +/-15 percent, equivalent to 5.65 to 7.48 versus the dollar. This would provide adequate flexibility for residents increasing their net foreign assets or any manner of structural changes. Brazil, India, and others may follow suit, and China could end up initiating the new currency order they have been talking so nebulously about for so long.

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