Reforms, Fast and Slow: The Near-term Outlook for Reforms to China’s Exchange Rate Policy



THERE is the sweet scent of reform in the air these days in Beijing, but not all reforms are equally sweet for China’s leadership. Many analysts are optimistic about the prospects for reform following Premier Li Keqiang’s speech to the National People’s Congress on March 5th, and also with the recent announcement that by the PBoC that the daily trading band on the renminbi will be widened to +/-2% from the previous +/-1%. Some of this optimism is certainly justified. However, despite official statements calling for further internationalization and marketization of the renminbi, reforms to China’s currency policy have been slow and inconsistent thus far, and the outlook for deeper, more meaningful market reforms remains dubious.

Last November, calls from the highest levels of Chinese officialdom lamented the inefficacy of continued interventionist policy, leading some to believe deep and aggressive reforms could be just around the corner. Indeed, the renminbi appreciated to its lowest historical levels following those speeches. However, the widening of the daily trading band is a small measure which has been widely expected and does very little to enhance the overall liberalization of the currency. The PBoC still retains the ability to set the fixing rate (the rate around which the market clearing rate ‘floats’), and thus retains absolute autonomy over the pace of appreciation, irrespective of how wide the trading band is. A more concrete step in addition to widening the trading band, for example, would be to pre-commit to set the daily fixing rate +/- 1.5% (more, or less) of the previous day’s closing price. This way the market would have an explicit role in determining the pace of appreciation (or depreciation). However, a step that would limit the PBoC’s absolute discretion over the currency seems unlikely at this stage.

Exhibit 1: CNY fixing rate versus CNY closing price

Source: Bloomberg, PBoC

Exhibit 2: Renminbi level and deviation from fixing rate

Source: Bloomberg, PBoC, author’s calculations

Exchange rate reform is a low priority for policymakers this year. Currency reform was buried deep in Li Keqiang’s much-publicized speech on reform priorities for 2014. In contrast, fiscal and financial reforms were placed in the front and described as “major priorities.”

In addition, the two major exchange rate reform measures the Premier highlighted for 2014 did not indicate a major change form the status quo. First, the Premier’s call for widening the exchange rate band (扩大汇率双向浮动区间) appears now to be complete and a further widening is unlikely. The second objective to maintain the policy of “stabilizing the exchange rate” (保持人民币汇率在合理均衡水平上的基本稳定) is hardly a call for injecting more market forces.

What, then, can we expect to see in the coming weeks and months? If the last several months are any indication, expect continued intervention and reserve accumulation. Following the release of December’s TIC data last month, many analysts simultaneously cheered and feared the drop in China’s dollar asset holdings. As we noted in a previous post, this was hardly the whole story. Indeed, with January’s release of China’s US Treasury holdings, it appears as though they’re back on track, although not as strong as the fourth quarter of 2013. This view is further corroborated by the NBS’s data on banks’ change in FX positioning, which is a strong indicator of intra-quarter reserve accumulation.

Exhibit 3: Change in FX positioning by banks vs. change in FX reserves

Source: Bloomberg, author’s calculations

Exhibit 4: China’s holdings of US Treasuries

Source: US Treasury

That said, if doubts about near-term growth in China persist, there is likely to be less external pressure to intervene. As Jim O’Neill at Bruegel recently noted, this could indeed be an opportune time to ‘loosen’ controls on the currency, while appreciation pressure has abated. However, if the recent sharp depreciation was prompted, as many reports would indicate, by direct official actions to break the perceived one-way trade, this will harm both speculative market participants as well as more constructive ones. More broadly, if officials are willing to ‘punish’ the market for exploiting an arbitrage opportunity that China has itself created and even promoted, this could make constructive holders – such as (limited) central banks and international corporations – of the currency less sanguine about the risks involved in holding and dealing in the currency. Gaining genuine buy-in from these important market participants will require predictable and well-communicated policy changes that will enable all participants to easily take either side of the renminbi trade and do so based on fundamentals. Forces that move markets are broadly observable or measurable; those that move officials in the PBoC are not. Inconsistent policies and communication will ultimately be damaging to the very ends the PBoC is seeking to achieve.

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