CHINA’S ERRATIC YUAN POLICY
China these days seems even more of an enigma than usual, especially its policy toward its currency, the yuan. Earlier, things were clear. China held its yuan rigidly cheap to the dollar in order to promote exports. Starting in 2005, however, the People’s Bank of China (PBOC) allowed a very controlled appreciation in the yuan. That halted abruptly in the second half of 2008, when the PBOC returned to rigid control. After 2010, the appreciation resumed. It continued more or less steadily, except for a pause in the middle quarters of 2012, until this year, when, in early March, the PBOC abruptly entered foreign exchange markets to drive down the yuan’s dollar price, significantly given past behavior. The authorities have pushed it down since.
As the new book, Thirty Tomorrows makes clear, this seemingly erratic behavior reflects Beijing’s difficulties with two contradictory objectives. On the one hand, the authorities want to continue export promotion by keeping the yuan cheap to the dollar. On the other, China realizes that it cannot count on exports indefinitely, that it needs to engage a domestic growth engine, and the appreciation and internationalization of the yuan serves that purpose, as well as Beijing’s perennial desire for greater global prestige and power. Since 2005, this latter objective has dominated, though in periods of economic adversity, Beijing has readily retreated into its older, cheap-yuan-pro-export posture. No doubt, this on-again-off-again pattern will persist for some time to come, slowing the pace of yuan internationalization and delaying the day when the yuan can present itself as a reserve currency, much less as a replacement for the dollar.
China’s present currency policy has its roots in a 2005 paper. Produced by the PBOC and entitled “The Timing, Path, and Strategies of RMB Internationalization,” it, along with other Chinese government research, pointed out that Chinese exports had limits. They had risen from a negligible part of the global trade in the mid-1990s to fully 12 percent. Since a comparable expansion was all but impossible over the next ten years, especially given the increased pressure on China from the United States and the European Union, China decided to supplement exports with a more domestic growth engine and so allowed yuan appreciate, though in an extremely cautious gradual way.
Events surrounding the 2008-09 financial crisis and recession accidentally reinforced this decision. On one side, they demonstrated the vulnerability of the export-based growth model. As the global economy sank and China’s exports fell, layoffs in China came fast and social unrest, including considerable rioting and anti-government violence, followed just as quickly. An additional and unexpected insight emerged when the government tried to relieve the economic pressure with massive infrastructure spending beginning in 2008. These outlays were meant primarily as a temporary, substitute jobs program, but they had such a remarkably positive economic response that Beijing could not help but see the great economic potential of broad-based development away from the established, coastal export centers.
Free to contemplate a future in which the PBOC could allow yuan appreciation, the authorities in Beijing came to see other benefits of a stronger, international yuan, held and traded widely in the world’s financial centers, maybe even a reserve currency held by central banks: 1. Yuan held overseas would reduce transactions costs for Chinese business. 2. More international contracts denominated in yuan would reduce exchange risk for China-based businesses. 3. When foreigners, including central banks, hold yuan, China can buy goods and services without having to exchange its own products in return. This seigniorage, as it is called, is something the United States has enjoyed for all these years that the dollar has served as international currency generally and especially as the world’s leading reserve currency. 4. With the yuan held abroad, China’s macro-economic policies have greater flexibility because they no longer have an immediate reflection in trade flows. 5. The more presence the yuan has in trade and global financial dealings, the greater prestige and influence Beijing enjoys.
But China has taken a go-slow approach. Whenever economic trouble appears, it has abandoned internationalization project in order to protect its exports. Beijing knows that for the time being it has much to do before consumption and other domestic economic activities can fully substitute for exports as a driver of growth and employment. Consumption, for instance, constitutes a mere 30 percent of the economy, compared to 70 percent in the United States, for example. Though a rising yuan will help adjust the mix toward domestic efforts, by holding down domestic rates of inflation and encouraging consumer spending among other things, the existing reality keeps the authorities alert to any yuan rise that could harm exports unduly in the interim. Such concerns will prevail for a long time to come.
Accordingly, the PBOC has engineered only the most gradual yuan appreciation, one that it will willing stop whenever the country faces adverse economic or financial conditions. Thus, when the global recession of 2008-09 threatened China’s export industry, the authorities put long-term yuan appreciation efforts on hold in order to secure a greater share of the then shrinking global export market. The PBOC blocked even the least yuan appreciation until 2010, when Beijing was sure that the worst of the global recession had lifted. Then again, in the middle quarters of 2012, when China’s economy seemed to weaken and faced questions about financial stability, the PBOC again stopped the yuan’s advance, only allowing it to resume when the economic and financial clouds lifted. Perhaps this latest move by the PBOC to drive down the yuan’s price reflects the recent news of Chinese economic weakness. But this latest move also seems to reflect something else, very likely Beijing’s need to grapple more than previously with the financial ramifications of its efforts to internationalize the yuan.
China has had a lot of trouble adapting its financial system to the new policy. It has done reasonably well where trade finance is concerned, setting up currency swap agreements with other central banks to increase overseas yuan liquidity, gradually widening in the trade transactions eligible for settlement in yuan, and increasing the amount of export invoicing denominated in yuan. But on the asset side of the financial equation, things have gone less smoothly, largely because of Beijing’s desire for control. So, for example, the offshore yuan bond market, called the “Dim-Sum” market, though essential for the full internationalization of the yuan, has grown only slowly, largely because Beijing has continued to try to insulate its domestic financial markets by imposing limits on how much bond issuers can use the yuan proceeds in China. Similarly, the “Panda” bond market, set up for foreign firms to issue yuan-denominated bonds in Shanghai, has failed to take off because of conflicting, official controls. The recent decision by Beijing to control lending by effectively shutting down China’s shadow banking system in favor of state-run banks is of a piece with these other positions.
This approach to finance might help protect China’s financial markets from shocks, but it will also prevent the full internationalization of the yuan. No currency can gain global attention much less become a reserve currency unless economic agents across the globe can use it freely in accounts, borrow it freely from financial institutions or through bond issuance inside the country and outside it, and trade assets denominated in it just as freely. To create such milieu, Beijing will need to let borrowers and lenders, domestic and foreign, enter and leave markets easily and use monies raised for a wide variety of purposes, alongside state banks, even with them. As long as the authorities thwart such movements for whatever reason, the yuan will fall short internationally, even relative to China’s trade or the size of its economy. The yuan will pale as a reserve currency, much less challenge the dollar.