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Solving the RMB Dilemma

The Chinese authorities face a range of challenges as they seek to protect the economy in the face of
downward RMB pressure.

In 2016 the Chinese authorities are assumed to have
intervened in the currency markets, not in order to depreciate
the RMB but actually to maintain the value of the currency.

“The consensus from economists is that there’s going to be
downward pressure on the RMB,” noted Shawn Baldwin,
chairman of AIA Group, on the opening panel at Profit & Loss
Shanghai.
This consensus is so strong that even when manufacturing
numbers and economic indicators have been strong, it’s lead
to questions from the financial markets rather than a positive
reaction, he said.

Commenting on the expectation of RMB weakness, Shu Lin,
professor, chair of the Department of International Finance;
director of the Research Centre for Money and Finance at
Fudan University, observed that, “Right now, the RMB exchange
rate is in a very awkward situation because there is not a firm
foundation for depreciation.”

He pointed out that China’s growth is still outstripping most
major economies by some distance, its FX reserves remain high
and in terms of exports it still enjoys a surplus, so there is not a
real foundation to support a massive depreciation of the currency.

“So why is there still an expectation of depreciation?
Because in the past there was an over-appreciation of RMB,
China’s economy is facing a downward pressure, the US dollar
is strengthening and that leads to some panicking sentiment in
the market,” says Lin.

He adds: “So we see an awkward dilemma for RMB: if you
allow for more flexibility, the depreciation will be very sharp and
create some regional panic or even a crisis. But if you maintain
stability like the central bank does, it’s not going to be
sustainable because if there is an expectation for depreciation,
that will be a long-term expectation.”

Lin argued that in principle, the Chinese should allow for
more flexibility in the RMB, but added that the timing for
allowing such flexibility will be key.
One of the big issues raised by the expectation of RMB
depreciation is that it can cause capital flight out of the
country, as firms seek to get money out before its value
decreases.

The response from the Chinese authorities has
been to impose capital controls and intervene in the FX market
to maintain the value of the RMB, but it remains to be seen for
how long this approach can be sustained.

“In Q3 and Q4 last year many Chinese firms, in order to avoid
the impact of RMB depreciation began to take some hedging
measures and we saw some capital outflows. But from the
beginning of 2016, with the economy recovering, the capital
outflows slowed down because of the government policies and
measures to control capital,” said Feng Guo, chief
representative and chief China economist at the Institute of
International Finance.

He continued: “But with the US dollar going up and the RMB
going down, I expect the capital outflows in the next few months
will return to the pace we saw last year. Or can the PBOC control
the pace of RMB depreciation and capital outflows?”

Guo noted that it is not necessarily clear that the PBOC will
be able to do so indefinitely, given that in the past year alone
its FX reserves have dropped from $4 trillion to $3 trillion as a
result of its intervention in the currency markets.

However, Baldwin claimed that “even though to date the
PBOC has been criticised” for their actions, they’ve actually
“done a very good job” of managing this dilemma.

“Up until last April, the capital flows out of China were getting
horrendous, so the PBOC put the brakes on it, and they did so
wisely because a lot of that money was flight and it was hurting
the economy. They pushed all that back and then began to get very
aggressive with their policy, so it seemed every night if you were
trading on a desk you had to wait and see what the PBOC was
going to do, it was like a Fed auction every night. Things weren’t
clear and it made you very unstable when trading,” he said.

Baldwin commented that the PBOC approach was to work
the other side of a trade against anyone trying to short the
currency or go long against the currency.

“A lot of people got their fingers burnt by this, but they
stopped trying to trade the currency this way. The PBOC was
very effective in not getting caught in a carry trade. The second
component of this was that people stopped ferrying capital
outside of the country. In some places people were literally just
carrying money over to Hong Kong and this was bad for the
economy, so the PBOC has shown that it is going to control this
landing of their economy,” he said.

Galen Stops

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