作者 | Herbert Poenisch，浙大AIF學術委員、BIS原高級經濟學家
China at 70: Free of fear of floating
By Herbert Poenisch, member of academic committee, AIF；former senior economist, BIS
China can be proud of its achievements on its current anniversary. From a backward country ravaged by foreign aggression and civil war to the second largest economy, admired and emulated by its peers. One sign of national prowess is the strength of its currency. This year RMB is celebrating 10 years of going out into the world, the process of internationalisation.
What started as a courageous idea has now become reality, accepted by authorities and markets alike round the world. The inclusion of RMB in the SDR basket in 2016 marks the recognition by authorities and the growing use of and investment in RMB marks the growing confidence of market participants. As President Xi calls it, the visible hand, the authorities partnering with the invisible hand, the financial market participants.While China has grown into its global role by constant learning, a gradual approach following Chinese tradition, it has been held back by fear and trepidation during this process. One of these is the fear of floating, the other one the remaining capital controls. These two together should prevent the national currency being at the mercy of global markets. While the Chinese financial sector is underdeveloped, such caution is reasonable. The wellbeing of Chinese people should not be subject to the whims of powerful financial market players. However, in early August we saw a bold move on the exchange rate, letting it cross the 7 RMB/USD mark, due to suspension of intervention. Maybe this marks the dawning of a new era?While many EMEs are afraid of this step, the so called 'fear of floating', Chinese fundamentals are different from other EMEs, which suffered from financial crises as a result. This article will revisit the underlying theories, 'fear of floating' as well as the 'original sin' against the background of EME countries' experience. This will be followed by recent RMB exchange rate developments and policy reactions. Periods of more market determination of the exchange rate have been interrupted by intervention and administrative measures such as the counter cyclical adjustment factor. If the RMB is to play a global role, it should follow the other SDR currencies and float freely even with some capital controls in place, unless extreme situations require intervention. Finally, it will be argued that Chinese fundamentals are different from other countries, allowing a more courageous exchange rate policy.
1.Theories of fear of floating and original sin
The theory which has been put forward in 2000 by Calvo and Reinhart follows various crises in EMEs between 1970 and 1999. Although declaring a floating regime, authorities clung on to an overvalued exchange rate, putting the adjustment burden on reserves and domestic monetary policy. They called it a crisis of credibility. A similar theory of crisis was put forward by Borio and Lowe, which stated that an overvalued exchange was a main early warning indicator of crises, together with rapid credit expansion and rising asset prices.
The theory by Calvo and Reinhart  states that many EMEs have a mismatch in their national balance sheet, ie excessive borrowing in USD which is not matched on the asset side due to the domestic component of the money creation. Many of these countries are exporters of raw materials. Once an external shock arises, they resort first to using forex reserves for intervention, followed by domestic adjustment, mainly through raising interest rates. Once these have been exhausted, the exchange rate crashed with dire consequences for these economies. They tested their theory in 39 countries in Latin America, Asia and some advanced economies between 1970 and 1999.Although the annual IMF Exchange and Trade Restrictions Report lists most countries as floating or managed floating, many of them have a sticky peg in reality, due to the fear of floating.The factors which cause a fear of floating are substantial liabilities in foreign currency which become heavier after devaluation, the inflationary impact of a devaluation, latent capital flight and loss of the fragile credibility.The importance of liabilities in foreign currency, the resulting mismatch in the national balance sheet has been addressed by the 'original sin theory'. This was put forward by Eichengreen, Hausmann and Panizza  in 2003. Countries unable to borrow in their own currencies have resorted to borrowing in international currencies, first and foremost the USD.Finally, the theory of banking crisis by Borio and Lowe  highlights early warning indicators, either single ones such as the exchange rate, or a combination of variables such as rapid credit expansion and sticky exchange rate as signals. The characteristics of the exchange rate is that a crisis follows closely after the loss of the anchor.While these theories hold true under restrictive circumstances, the recent reality has been defined by greater exchange rate volatility caused not only by asymmetric shocks, but reinforced by capital flows. EMEs have increasingly adopted inflation targeting regimes similar to advanced economies and learned to live with greater external volatility. Fear of floating has been replaced by truly managed floating.In the recent period, capital flows associated with exchange rate fluctuations affect macroeconomic and financial stability through three main channels (i) exchange rate pass-through to inflation, (ii)export competitiveness, and (iii) domestic financial conditions . Capital flows are known to change direction, necessitating domestic policy measures. Capital inflows into EMEs after the GFC and adoption of unconventional monetary policy in major advanced economies led to appreciation of local currencies. The tapering of extraordinary measures in advanced economies, such as raising interest rates from the lower bound, led to a reversal of capital flows and weakening of EME currencies.Within this new environment, central banks have been constrained to apply the traditional monetary policy measures as these might have had an adverse cyclical impact on the domestic economy. In times of inflows, lowering interest rates and raising them during outflows had procyclical effects. Therefore they resorted to macro prudential measures and capital control measures to manage the impact of greater exchange rate volatility and capital flow swings.
2.Recent exchange rate developments and policy reaction in China
The present inflation targeting scenario in EMEs has sharpened countries to manage exchange rate volatility and capital flow swings. China neither adopted a clear monetary policy regime nor clearly weaned itself from shadowing the USD. In the perception of forex markets, China still pegs to the USD, perhaps less rigidly than before. Therefore the move to allow the RMB to cross the threshold of 7 RMB per USD in early August was a clear sign that China is ready to join other EME countries in accepting greater exchange rate volatility . Yu and others cite reduced forex intervention and thus reject the accusation by the US administration of currency manipulation.
While China's resolve as well as the pain threshold has to be tested, it is a welcome step in line with other members of the SDR basket. The way has not been straight forward  following China’s tradition of feeling stones while crossing the river.The process started in 2005 when the RMB was delinked from the USD and pegged to an undisclosed basket of currencies. China announced a managed floating regime and the PBoC would announce a central parity rate, the usual fixing. Floating against the USD would be within a narrower band of +/-0.3% whereas within a wider band +/- 1.5% against the other major currencies. By 2014 the band was widened to +/- 2% against the USD. It also allowed currency forwards and swaps.However, in reality the short term bilateral RMB/USD rate did not move much, reflecting heavy intervention. Thanks to current account surpluses, foreign exchange reserves rose from USD 800bn in 2005 to USD 4tr in 2014. During the USD appreciation following the GFC, the RMB even appreciated in nominal effective and real effective terms, feeding expectations of further strengthening. This led to capital inflows and carry trade, through indebtedness in USD markets. Chinese entities borrowed at historically low USD interest rates, expecting lower debt servicing and repayment burden.When sentiments changed and higher USD rates were expected, the so called tapering, capital flows swung into substantial outflows in 2015. Very soon, the carry trade was reversed and foreign liabilities were repaid, reducing foreign indebtedness. In addition there were legal and illegal capital outflows based on the expected depreciation of the RMB. In August 2015 markets were surprised by an announcement supporting a market determined exchange rate, as the closing rate was to be the central parity next day.As of end 2015 China started publishing the CFETS index as well as the SDR and BIS forex index as guidance for commercial banks functioning as market makers. The capital outflows continued, mitigated by capital flow measures and intervention until mid 2016. The RMB depreciated against the CFETS basket by 10% by then but remained stable afterwards until the end of 2017. McCauley and Chang Shu called this the golden period when peers and markets gained confidence in China's own foreign exchange regime . As a result, the co-movements between RMB and partner currencies became closer, the start of a RMB zone. However, this period was short lived when fear of floating took the better of Chinese authorities again.In early 2017 guidance was put into banks' daily quotes to stem irrational depreciation expectations and counter pro-cyclical herding. Banks were asked to adjust their daily quotes by a counter-cyclical adjustment factor(CCAF). This factor continued to be used until recently, in addition to forex intervention during the period of rising trade tensions in 2018. It also reinstated a reserve requirement of 20% on banks’ forward positions against depreciation herding. Nevertheless, RMB continued to slide until intervention was suspended in August 2019 and the threshold of 7 RMB/USD was crossed. This was not followed by disorderly market conditions and herding, resulting in a depreciation spiral as some had feared. Thus fear has been overcome and peers and markets will gain confidence once the new regime becomes transparent. It is yet unclear what will replace the quasi exchange rate target, as monetary policy is pursuing a number of objectives, quantitative as well as some form of inflation targeting. Clarity and its pursuit will be beneficial for all.
3.Why China need not fear floating?
Different from other EMEs, China's fundamentals do not warrant such a preoccupation. Firstly, China is not a commodity exporter, which has to accept world prices. China's diversity of exports has allowed it to influence USD prices to such an extent as to positively affect global inflation. This might be changing due to domestic wage pressure which can no longer be absorbed by exporters.
There is no sign of misalignment of the exchange rate, either measured by the nominal effective nor real effective exchange rate . The IMF has concluded that the real effective exchange rate is roughly right, thanks the China's prudent exchange rate policy. This is a clear repudiation of the US accusation of currency manipulator.Foreign borrowing was accelerating after the GFC until tapering started in 2014. Non-bank foreign borrowing was replaced by domestic borrowing, thus reducing the currency mismatch in the national balance sheet. With foreign liabilities currently amounting to only 14.5% of GDP  this well under control, given the ample foreign exchange reserves amounting to close to 20% of GDP. These are ample reserves which have been used until very recently to shore up the RMB. China’s interest policy is decoupled from the international scenario thanks to capital controls. As a result China has never been forced to raise interest rates regardless of domestic priorities in order to defend the RMB. Economic cycles have converged since the start of the trade tensions and China is in the same position as the US and the EU trying to stimulate the economy by various means.The only concern is that because of declining current account surpluses, the short term debt service coverage has declined from over 384%in 2015to 257% in 2018 . This is still not a critical level.The only major risk which has been flagged by the BIS and others is the rising credit to GDP ratio as well as the overall debt service ratio (DSR) . However, as this is financed domestically behind a porous but still effective wall of capital controls, the threat for a currency collapse is remote. Regarding the original sin, China is not in need to borrow externally to sustain domestic growth. In addition, thanks to the strategy of internationalisation of the RMB, foreigners are more than willing to purchase Chinese liabilities denominated in RMB. The holding of CGBs by foreigners has increased to 8%, which is still small by international standards, but at the same time not risky for the exchange rate in case markets unwind positions.Overall, China is based on far more solid fundamentals which do not warrant a fear of floating nor the haunt of the original sin. This allows China to forge ahead with a foreign exchange regime corresponding to its economic position in the world and with the RMB status as part of the SDR basket. In addition, the strategy of internationalisation of the RMB will give China more leeway to free itself from the constraints suffered by other EMEs.
4.Conclusion: Requirements of a global RMB currency
There are basically two steps towards this goal, admitting a freely floating currency regime and installing a credible monetary policy regime. Both under the conditions of continued capital controls.
Of the 5 major currencies in the SDR basket only the RMB is not in the group of free floaters in the IMF Exchange and Trade Restrictions Report. It comes under crawl-like regimes with the comment managed floating in reality . Now that regular intervention has been suspended , China should join the group of free floaters sooner than later. This would be a strong counter argument to US accusation of currency manipulator.This does not mean that the bilateral exchange rate, notably to the USD does not matter. Countries' preferences differ, with Japan publicly declaring where it would like to see its USD exchange rate. It would be part of a basket of currencies, such as the CETS basket. China's exchange rate policy on the way to free floating could be a composite regime, with a stabilised arrangement similar to Singapore.However, the main policy thrust is domestic, such as inflation targeting, paying attention to food prices and housing prices. The bilateral exchange rates should be determined by markets, even given the financial account restrictions. The greater volatility and risks should be made clear to the public. Once partner currencies, in particular those of Belt and Road countries are convinced of such a strategy they will follow China by pegging to the RMB, as they did during the 'golden period' referred to above.The second pillar will be a transparent and sustainable monetary policy regime, such as inflation targeting which can easily be verified, to dispel suspicions of hidden exchange rate target. This will still leave China with all the monetary policy levers necessary, supplemented by macro prudential tools as well as capital account measures, in case of disorderly market conditions. The emphasis will be shifted to the domestic scenario rather than to the foreign considerations presently. Thus China can assume the leading role among Belt and Road countries, a role long overdue due to its clout in trade and investment.
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