Men 1988 Paul KrugmanThe Nobel Prize-winning economist writes that the world is “pretty likely” to move away from freely floating exchange rates soon. Instead, the government will adopt a system of “broad target zones”, promising that the currency will not move significantly above or below the fixed exchange rate.
He was wrong, but we can see a version of this future in China. Every morning, the central bank sets the RMB exchange rate, called a “fix”. The Chinese currency can fluctuate 2% above or below this rate every day. The zone is narrower than Krugman expected, and its midpoint moves in discrete steps each morning. Still, it’s similar enough that an economist at the University of Hamburg calls it a stepped “moving Krugman-Band his system.”
The stairs are tight these days. Since mid-April, the renminbi has depreciated by about 10% against the dollar. The morning correction slowed (but didn’t stop) the decline. In the course of the decline, the currency crossed a psychologically significant threshold. In August the dollar crossed 6.8 and from 2008 he was close to the level to which the renminbi was pegged after the 2009 global financial crisis. The central bank set a correction of more than 7 yuan to the dollar on his Sept. 26, for the first time since the early stages of the covid-19 pandemic.
The reason for this decline is clear. The US Federal Reserve has aggressively raised interest rates to curb inflation. To stabilize the yuan, China’s central bank may raise interest rates at the same time. But tightening monetary policy would be at odds with the needs of a weaker economy hampered by a downturn in real estate and stringent COVID-19 regulations.
It is not very clear where the bottom of the stairs is and how sure the descent is. Some analysts fear a repeat of 2015, when an insufficient devaluation of the yuan led to capital outflows, further weakening the yuan. However, it is unlikely that it will be rebroadcast. The renminbi is no longer overvalued. Its target zones are better managed and its capital management is better implemented. In the past, China pegged its currency to the dollar because it feared a significant decline would cause its currency to appreciate. A chaotic depreciation of the renminbi against the dollar is less likely. As such, China is reducing its efforts to stop it.
When evaluating China’s currency choice, economists sometimes cite an “impossible trinity”. A country may want exchange rate stability, currency independence, and free capital flow, but of these he can only have two. Rich countries usually make clear choices. As Joshua Aizenman of the University of Southern California points out, emerging economies are more murky. Many companies adopt a variety of positions, neither outright embracing nor outright rejecting their purpose. For example, by imposing limited control over capital, exchange rates can be stabilized to some extent without completely giving up currency independence.
China is more obsessed with exchange rate stability than other countries. Not to mention the South African rand and the Brazilian real, the yuan is less volatile than the Indian rupee. But China has also adopted stricter capital controls, especially since her 2015. This can be inefficient and inconvenient. However, it is not outlawed by the Impossible Trinity.
China can also take comfort from economic fundamentals. Despite being insulated from market forces, its exchange rate is moderately undervalued. According to the Institute of International Finance, adjusting for inflation would be about 10% below fair value. This year has remained stable against a wider basket of currencies. If only the fundamentals were applied, there should be no plunge.
Unfortunately, financial markets do not respect such calculations. “Few people will pay attention to fundamentals…in a time of turbulence and turmoil,” Zhou Xiaochuan, then governor of China’s central bank, said in 2016. .
Krugman showed that this problem can be ameliorated by turning speculators into stabilisers, if the target zone is trustworthy. Further downside is limited as the exchange rate has hit the bottom of the zone. Knowing that, speculators push it back to the middle. The mere prospect of intervention by the authorities may render actual intervention unnecessary.
China in 2015 did not work as one of the reasons why the stairs were made. Each morning’s correction was to reflect the currency’s value at the end of the previous trading session. Therefore, a speculative drop during trading could be incorporated into the correction the next morning. In a day, the zone can constrain speculators. But from one day to the next, speculators may move zones.
need to fix
To restore stability and confidence, China sold more than $700 billion in foreign exchange reserves in 2015-2016 and implemented capital controls more aggressively. It introduced a mysterious “counter-cyclical factor” into the calculation of the morning correction, intended to offset the speculative momentum. It also made it more expensive to bet against the renminbi because it imposed reserve requirements on banks. This requirement he removed in 2020 and was restored last month.
With these steps in place, China appears more confident that the yuan can depreciate against the dollar without the depreciation becoming self-reinforcing. For this reason, the renminbi does not currently appear to be pegged to the US currency. Economists have examined how closely the yuan mimics the dollar’s movements against other currencies. In the dark ages of 2015, we worked one-on-one. According to Chen Chan et al. of the National University of Singapore, the dollar’s influence has been steadily declining in recent years, dropping from 1 to about 0.3.
China may stick to the dollar more strongly during times of major financial stress. But otherwise, it is unlikely to intervene significantly to protect the renminbi’s particular value against the dollar. As long as it doesn’t roll over. ■
Read more about our column on economics, Free Exchange.
Economists now admit exchange rate intervention could work (September 29)
China’s rulers seem to have given up on a slowing economy (September 22nd)
A richer society means fewer babies. right? (September 15th)
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https://www.economist.com/finance-and-economics/2022/10/06/why-chinas-policymakers-are-relaxed-about-a-falling-yuan Why Chinese policymakers are optimistic about yuan depreciation