Why China’s central bank is caught between a rock and hard place unless it allows the renminbi to float freely
Paola Subacchi says the complexity of dealing with the devaluation of the renminbi amid the trade war underlines the need for China to allow the value of its currency to be truly determined by market forces
To be sure, with more than US$3 trillion in foreign reserves and an established – albeit not entirely successful – system to manage its exchange rate, China has enough financial and monetary leverage to bring the US economy to its knees. But having the weapons it needs does not mean that China can afford to use them.
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Others suspect that Chinese monetary authorities intervened to weaken the renminbi, in order to offset the impact of US policies.
The Chinese government has a long history of intervening to ensure that the renminbi’s exchange rate aligns with its economic goals.
Still, despite PBOC Governor Yi Gang’s insistence that China’s exchange rate reflects demand and supply (with a basket of currencies as a reference), monetary authorities have the power to intervene when necessary. And though such interventions have been less frequent than in the past, they have continued to muddle market signals.
In the context of today’s trade war, however, an “engineered” competitive devaluation of the renminbi, even if technically possible, would not be in China’s best interest.
Unlike in the past – and despite the Trump administration’s view of China as an unreformed currency manipulator – a weak renminbi has more costs than benefits for China.
Finally, and more crucially, a weak renminbi at the same time that dollar-denominated assets become more attractive could cause China to suffer capital flight. In this scenario, Chinese monetary authorities might be forced to reverse course and prop up the renminbi.
China thus finds itself between a rock and a hard place. To discourage new lending and reduce the risk of capital outflows, the PBOC should tighten monetary policy.
But counteracting the negative impact on growth resulting from rising US interest rates and tariffs calls for more monetary accommodation.
In the event, US interest rates could go through the roof, implying serious risks for global financial stability. So, while a weak renminbi is worse for China than it is for the US, a PBOC intervention to strengthen the currency could undermine the Fed’s policy normalisation and financial stability generally.
China’s lack of a fully liquid and convertible currency means that there will always be a fundamental divergence of exchange-rate regimes across the international monetary system.
And this divergence will continue to produce distortions that intensify the global effects of new US monetary-policy trajectories.
The solution to this problem is straightforward: eliminate the distortions. China should float the renminbi so that its exchange rate becomes truly market-determined, even as it continues to manage capital flows. A “managed” approach of this kind would help China strengthen its financial system and develop the renminbi as a major international currency.
Unfortunately, China seems as beholden to its current exchange-rate regime as the Trump administration is to its trade policy. The US and China’s irreconcilable approaches are not good for anyone. We all should be concerned about what may come next.
Paola Subacchi is a senior fellow at Chatham House and the author of The People’s Money: How China Is Building a Global Currency. Copyright: Project Syndicate