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Economic Insights

What is behind Beijing’s abrupt shifts in policy regarding the currency’s value?

When it comes to currency policy, China these days seems even more of an enigma than usual. The yuan’s behavior has left questions about exactly where the county’s leadership wants things to go. Earlier, things were clear. China held its yuan rigidly cheap to the dollar in order to promote exports. But starting in 2005, signaling a policy change, the People’s Bank of China (PBC) allowed a very controlled appreciation in the yuan. That halted abruptly in the second half of 2008, when the PBC returned to rigid control until 2010, when 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 PBC abruptly entered foreign exchange markets to drive down the yuan’s dollar price, significantly, given past behavior. The authorities have pushed it down since.1      

Against such a backdrop, it is only reasonable for people to question PBC policy. As is often the case when behavior looks erratic, it likely reflects the play of two contradictory objectives. On the one hand, the authorities want to keep the yuan cheap to the dollar in order to promote Chinese exports, the county’s chief source of employment growth for some time now. On the other, China realizes that it cannot count on exports indefinitely, that it needs to engage a domestic growth engine, and yuan appreciation and internationalization 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 readily retreats 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.     

Why Change at All?
China’s present currency policy has practical and aspirational as well as accidental roots. On the practical side, the authorities have realized that export-led growth cannot go on indefinitely. The PBC signaled this realization in a 2005 paper, “The Timing, Path, and Strategies of RMB Internationalization,” which, 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%. A comparable expansion was all but impossible over the next 10 years, especially given the increased pressure on China from the United States and the European Union. Rather than fight the rest of the world, as well as practical probabilities, these papers recommended that China seek to supplement exports with a more domestic growth engine. Pursuing that objective and seemingly bowing to the pressure from Washington and Europe, the PBC began to allow the yuan to appreciate, though in an extremely cautious gradual way.2

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. Beijing awakened to how susceptible its economy was to events outside its control. 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 PBC no longer had to support exports by keeping the yuan cheap, the authorities in Beijing came to see other benefits of a stronger yuan, one that could become a truly international currency, held and traded widely in the world’s financial centers, maybe even a reserve currency held by central banks. Such a role was of course impossible while China’s policy stressed exports and a cheap-yuan policy, since an international currency, much less a reserve currency, always trades at richer prices than it otherwise might.  With less fear of a strengthening yuan, Beijing embraced at least five other benefits from an internationalized yuan.3

1. A widely traded currency and one 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 macroeconomic policies have greater flexibility because they no longer have an immediate reflection in trade flows.

5. The more of a presence the yuan has in trade and global financial dealings, the greater prestige and influence Beijing enjoys.   

Beijing’s Strategy and Its Failures
China’s leadership has approached this effort to internationalize the yuan with great caution. It has at least three reasons. One is the gradualism Beijing has always shown in just about everything it does. Second is the ongoing effort to protect China’s still-important export industries, at least until China’s domestic growth engine could fully develop. Third is Beijing’s concern that the open, broad financial market needed to support an international currency will interfere with its ever-present desire for top-down control.4    

The second of these considerations rears its head whenever economic trouble appears. Protecting its export share remains China’s failsafe position. As much promise as domestic development offers, Beijing knows that it will be a long time before it can replace exports as the prime driver of China’s economy and that China has much to do before consumption and other domestic economic activities can fully substitute for exports, or even supplement them adequately. Consumption, for instance, constitutes a mere 30% of the economy, compared with 70% in the United States, for example. Though a rising yuan value 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 PBC has engineered only the most gradual yuan appreciation, one that it is willing to 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 highest reaches of the Communist party made that goal clear. The PBC 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 it faced questions about financial stability, the PBC again stopped the yuan’s advance, only allowing it to resume when the economic and financial clouds lifted. Perhaps this latest move by the PBC 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.

Until recently, Beijing has approached the financial side of the yuan’s internationalization largely through aspects of trade finance. The PBC, has, for instance, set up currency swap agreements with a number of other central banks to increase yuan liquidity in support of the country’s trade. In a similar way, Beijing has gradually widened the trade transactions eligible for settlement in yuan and simultaneously increased the amount of export invoicing denominated in yuan. This has gone reasonably smoothly. It is the asset side of the financial support that has gone less smoothly largely because it conflicts with Beijing’s other desire for control. So, for example, the offshore yuan bond market (colloquially 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 from it with stark 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 similar, 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. A more open system would have managed the situation through more conventional monetary policy tools. 

This approach to finance might help protect China from the bad loans that could cause havoc in a different structure, but it also will 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.


1 Information from Bloomberg.
2 Benjamin J. Cohen, “The Yuan Tomorrow?” unpublished paper, 2011.
3 Ibid.
4 All information and data here and afterward from Milton Ezrati, Thirty Tomorrows (Thomas Dunne/St. Martin’s Press; forthcoming April 2014), especially Chapter 14.

ABOUT THE AUTHOR

Critical Releases in the Week Ahead

Milton Ezrati examines the key economic and financial releases scheduled for the coming week.

Key Mover:

FOMC Minutes*
Wed., April 9, at 2:00 p.m. ET

This official Federal Reserve statement will capture some of Chairperson Janet Yellen’s inflammatory description from her press conference, but otherwise show the same balance of opinion among policymakers as in the past, as well as the Fed’s commitment to maintain an easy monetary policy for some time to come, if not quite as easy as today. 
*Source: Federal Reserve.

Others to Watch:

Producer Price Index for March*
Fri., April 11 at 8:30 a.m. ET
Previous: -0.1% • Prospect: +0.3%

The drop recorded in February reflected a one-time plunge in transportation services costs.  Since that will not repeat for March, although food prices are still rising, a slightly above-trend rate of increase is likely.  If the transportation services reverse and recapture their old level, the figure could look very frightening, though it would not reflect the underlying situation. 
*Source: Department of Labor.

Consumer Sentiment for April*
Fri., April 11, at 9:55 a.m. ET
Previous: +0.1% • Prospect: +0.2%

With the market moving sideways, employment still sluggish, and geopolitical threats intense, this measure at best could move up only slightly.*Source: University of Michigan.

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