Knowledge@Wharton: "China’s Currency Test: Can It Get Capital Controls Right?"

From K@W:

To reform or not to reform: That is the question in China these days. The country is weighing a key decision over whether to simply loosen restrictions on its highly controlled capital account, or to make the yuan, also known as the renminbi (RMB), or “people’s money,” a fully convertible international currency.

Beijing’s dilemma over whether to accelerate the slow evolution toward full convertibility sharpened in August when the government devalued the yuan by almost 2%, catching the markets by surprise. That move unleashed a spate of turbulence that has yet to fully subside, and the most recent bout of acute volatility has accentuated concerns over China’s economic slowdown and its global repercussions. The confusion and anxiety are compounding as capital flows out of China, straining Beijing’s capacity to control the yuan’s value.

The 1.5% drop in the yuan’s value against the U.S. dollar in early January, to its lowest level in five years, reinforced suspicions that China might be opting to devalue the yuan — long overvalued in many economists’ estimation — to breathe some life into its export sector. Economists say Beijing has been failing to communicate its intentions effectively to investors and markets in the wake of the People’s Bank of China’s (PBOC) decision to cut its daily reference rate by 1.9%, triggering the yuan’s biggest one-day drop since China ended its dual currency system in January 1994. The PBOC China called the change a one-time adjustment and said it would better align the yuan with supply and demand.

Seeking to calm the markets and stem capital outflows that have picked up in recent months, on December 11, the PBOC issued a notice that the yuan’s value should be viewed in terms of a trade-weighted basket of currencies rather than just the dollar. That has in fact been the policy for years. However, that step just convinced investors and markets that the central bank was trying to weaken the yuan against the U.S. dollar and other currencies. China’s foreign exchange reserves dropped by a record $108 billion in December and declined by $99.5 billion in January.

Whatever the markets’ perceptions, what China did twice was to move toward greater exchange rate flexibility in keeping with its goal of making the yuan an international currency, says Louis Kuijs, head of Asia Economics at Oxford Economics. “What happened in August and December were moves by the PBOC to relinquish that link with the U.S. dollar and to make the first step toward eventual exchange rate flexibility. The first step that was recommended by many experts was to focus on the basket of currencies instead of focusing on the U.S. dollar,” Kuijs says. “They have tried to focus everybody’s attention more on the basket and keep on telling the market that we have move to focus on the basket rather than the bilateral link with the dollar.”

Opaqueness vs. Transparency

Much of the problem stems from a lack of transparency that is typical of China’s policymaking, since in reality the PBOC did not say explicitly that those were its motives and that in turn damaged its credibility at a time when investors were already worried about the possibility China might devalue.

“They are saying that we are not targeting this or that and they are saying there is no reason the RMB depreciates significantly against the basket,” Kuijs says. Since Chinese leaders have continued to claim they have no intention of weakening the yuan while taking steps that lead directly to that outcome, the market is “not buying or not completely believing what the policymakers are saying.”...MORE