Editorial: Central Bank Must Be Transparent Amid Global Currency Uncertainty
On the third anniversary of China’s August 2015 exchange rate reform, the yuan’s exchange rate has once more become a hot topic. Recently, the global financial market has been in turmoil. Some emerging markets, especially Turkey, have been caught in a currency crisis. This crisis may have a domino effect. The yuan has also been weakened against the U.S. dollar, and markets are watching for whether the yuan’s value will fall to 7 against the U.S. dollar.
In this context, the market is deeply concerned about what stance and measures China’s central bank will take. The mechanism for determining China’s exchange rate is more important than the rate itself. A transparent set of rules will be the key to guiding and stabilizing market expectations. The People’s Bank of China needs to further improve its mechanism for fixing the yuan’s midpoint, and it especially needs to clarify the rules for countercyclical adjustments.
Since the exchange reform of 2015, China has developed a floating exchange rate system based on market supply and demand, with adjustments based on a basket of currencies. In 2018, the central bank has temporarily suspended the use of countercyclical adjustments, and has basically ceased its usual foreign exchange intervention. The market reaction has been normal. The yuan’s exchange rate is expected to stay stable while the flexibility of its “two-way float” has been further enhanced.
Despite escalating trade friction between China and the U.S., the yuan exchange rate and China’s foreign exchange reserves have been sufficiently robust. Considering the strengthened dollar, the yuan’s performance is significantly stronger than that of other emerging economies’ currencies. It has also remained stable against a basket of other currencies. The central bank’s previous heavy use of its foreign exchange reserve to stabilize the exchange rate raised doubts. These days, China is increasingly moving toward a floating exchange rate mechanism based on market supply and demand. The country’s central bank has largely overcome its “fear of floating,” which is a commendable improvement.
However, the yuan exchange rate mechanism can’t be created in just one attempt. The central bank must instead gradually accumulate experience. The issue of the exchange rate is very complicated and involves many factors. It is difficult to reach a purely theoretical conclusion on what the “reasonable equilibrium level” of a country’s exchange rate should be. Instead, China must rely on practical exploration. At a time when pressure on China’s economic growth continues to increase, the market inevitably will be divided over the future of the yuan exchange rate. In order to prevent market turmoil and avoid triggering capital flight, China’s central bank must properly manage market expectations.
The question that the market is paying attention to is when and how the central bank will intervene. The mechanism for fixing the yuan’s midpoint is the core of China’s exchange rate reform. Since 2015, after much fine-tuning, this mechanism has on the whole become significantly more transparent. But certain sectors of the rules are still in a black box, and often lead to speculation and debate in academic circles and on the market. The monetary authorities have their own reasons for either strictly following the rules or acting unexpectedly. However, for many years, the trend has been to follow the rules. Not long ago, the leaders of the central bank and China’s State Administration of Foreign Exchange said that to improve the yuan fixing mechanism, it was necessary to allow market forces to play a more decisive role in order to improve the regularity and transparency of the exchange rate’s midpoint. The direction of exchange rate reform is clear.
The yuan’s current depreciation has once more given rise to speculation. In response to this, the central bank’s monetary policy implementation report for the second quarter dedicated a section to discussing how recent changes in the yuan’s exchange rate should be treated. This shows the authorities’ desire to communicate with the market. On the one hand, the report says that “the yuan exchange rate is mainly determined by market supply and demand, and the central bank will not use the value of the yuan as a tool for dealing with external disturbances such as trade friction.” On the other hand, the report also says that “while maintaining exchange flexibility, we must also adhere to baseline concepts. If it is necessary, we should maintain the smooth operation of the foreign exchange market through countercyclical adjustment of foreign exchange supply and demand.”
In principle, this two-pronged approach is self-evidently correct. However, in practice, the central bank has yet to clarify how it will manage the relationship between the two prongs. It should especially clarify when it will start using countercyclical adjustments in order to better manage market expectations and reduce the effects of the “herd mentality.”
Some people believe the central bank deliberately keeps its exchange rate policy opaque in order to maintain an advantage against market speculation. Additionally, the central bank also needs to learn more about how exactly it should intervene through practice. Whatever the circumstances, the central bank will undoubtedly become increasingly transparent about the relevant rules.
A currency’s value is naturally affected by external factors, but the deciding factor is still the fundamentals of the domestic economy. The recent collapse of the Turkish lira is a clear lesson to developing countries. In addition to being affected by the strength of the U.S. dollar and international trade friction, the lira’s plunge has its roots in the country’s high external debt and high inflation. In contrast, China’s economic fundamentals are far better, and the yuan is unlikely to depreciate in a similar way. However, China must still take the initiative to confront the deep-seated problems in its economic system and industrial structure.
At the moment, the market is closely watching whether the yuan’s value will fall to more than 7 against the U.S. dollar. The People’s Bank of China raised the foreign exchange reserve requirement for businesses using forward settlements, sending a message to commercial banks that the yuan should remain stable. For the Chinese economy, it does not make much of a difference whether the yuan is valued at 6.9, 7, or 7.1 against the U.S. dollar. The more one values the number, the more it will become a psychological barrier. Despite domestic financial risks, the divergence between U.S. and Chinese monetary policy, and the financial crisis in emerging markets, the current short-term depreciation of the renminbi (RMB) is mainly a risk-avoiding reaction by the market. In the face of a fluctuating yuan, the Chinese central bank can and should maintain its firmness, as long as it does not pose a systemic risk.
The marketization of the exchange rate and interest rate are among the few areas of reform in which China has made substantial breakthroughs in the past decade or so. Since its launch in 1994, exchange rate reform has been a difficult path to travel, but China is now closer to its goals in this area than ever. The monetary authorities should make unrelenting efforts to achieve full success. The main direction should be to further improve the mechanism for determining the yuan’s exchange rate while increasing its regularity, transparency, and marketization. Only when the RMB floats freely can the capital account be liberalized and will there be a truly internationalized yuan.
Translated by Teng Jing Xuan (firstname.lastname@example.org)
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