China Sows Confusion Over Currency Policy

An analysis by Michael Lelyveld
2016-06-13
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A Chinese pedestrian takes photos of the headquarters of the People's Bank of China in Beijing, May 4, 2016.
A Chinese pedestrian takes photos of the headquarters of the People's Bank of China in Beijing, May 4, 2016.
ImagineChina

China's conflicts with foreign news reporting have added to doubts about its currency policies as it tries to maintain confidence in the economy and control over capital flows.

Last month, The Wall Street Journal reported that the People's Bank of China (PBOC) had effectively abandoned a reform of exchange rate policy announced last August to make the value of the yuan more market oriented, putting daily rate setting decisions "back under tight government control."

Under the announced policy, the PBOC says that it sets a central parity rate, or "fixing," based on a weighted average of market prices on the interbank market, allowing the value to rise or fall by 2 percent against the U.S. dollar in domestic trading each day.

The rate setting system is one of a series of compromises that China has made since 2005 under pressure from international demands for free trade in its currency.

Although the yuan's value is influenced by the daily fixings, it fluctuates freely on markets abroad.

Last December, the PBOC added a further wrinkle following criticism of unexplained devaluations, arguing that the yuan fixings should be measured against a basket of 13 foreign currencies instead of the dollar alone.

In relation to the basket, the yuan had actually strengthened over time, officials of the China Foreign Exchange Trade System (CFETS) said.

The details matter in part because China's trading partners have been on guard for any sign of currency manipulation that would give the country's exports an unfair price edge as the yuan weakens against the dollar.

Downward pressure

But downward pressure on the yuan in trading also reflects market concerns about underlying weakness in China's slower-growing economy.

Slippage in the currency runs the risk of snowballing if Chinese savers and investors start dumping the yuan to seek shelter in the dollar, using various dodges to evade China's capital controls.

But interventions to defend the yuan's value are costly to PBOC foreign currency reserves, which have dropped by U.S. $459 billion, or over 12 percent, since the market reform of last August was announced.

On any given day, the yuan may be driven up or down by unseen business or government interests, speculative bets and opaque PBOC responses.

The Journal story, based on secret minutes of PBOC meetings, angered regulators because it reported that they had quietly backtracked on reforms in order to maintain stability and were choosing between setting the yuan's value against the dollar and the wider currency basket at will.

Promises of greater transparency and market reforms figured largely in the International Monetary Fund's decision last year to include the yuan in its Special Drawing Rights basket of freely-traded major currencies, elevating its status abroad.

But there have been repeated signs of a bumpy ride for China's compliance with IMF guidelines since then.

In January, IMF Managing Director Christine Lagarde called for greater "clarity and certainty" in China's exchange rate management, "in particular with reference to the dollar, which has always been the reference."

Lagarde's comment came 16 days after an abrupt 0.5-percent drop in the yuan's fixing against the dollar on Jan. 7. According to the Journal story, the PBOC had already "ditched the market-based mechanism" at a closed-door meeting three days before.

china-bank-renminbi-may23-2016-400.jpg
A Chinese clerk counts renminbi yuan banknotes at a bank in Nantong, east China's Jiangsu province, May 23, 2016. Credit: ImagineChina
‘Fabricated’ story

On May 27, the PBOC issued a statement on its Weibo social media account, blasting the Journal story as "fabricated" and also denying a Bloomberg News report that it would seek advance information from U.S. officials about Federal Reserve Board plans to raise interest rates.

"We condemn such irresponsible actions, which contravene professional ethics of journalism, and reserve the right to pursue relevant responsibility through legal channels," the bank said, according to the International Business Times.

But since then, readings of China's currency policies have been anything but clear.

Yuan fixings have been up one day and sharply down the next, including a 0.45-percent depreciation against the dollar on May 30, hitting a five-year low.

In May, the currency fell 1.6 percent, its second-biggest monthly drop on record after an unexplained 2.7-percent devaluation last August, Reuters reported.

Analysts linked the late-May decline to expectations of a U.S. rate cut, but that possibility has been in the wind for months.

On June 1, Xinhua published a commentary arguing that "a sharp depreciation of the currency is less feared this time" because of "more policy transparency."

"Compared with before the overhaul last August, the current mechanism is more market-based, setting the yuan's value with more reference to a basket of currencies instead of the dollar alone," Xinhua said.

The qualifier of "more reference" made it appear that the PBOC had not settled on one reference point or the other.

One day later, Xinhua ran a second commentary suggesting that the recent volatility "is likely to encourage China's central bank to push through with more capital account liberalization and FX (foreign exchange) reform measures."

Uncertainty over the yuan continued Monday as the PBOC lowered the daily fixing by 0.3 percent against the dollar following a series of largely disappointing economic reports, indicating slower growth in May.

Speaking at Tsinghua University in Beijing on June 5 before the U.S.-China Strategic and Economic Dialogue meeting, U.S. Treasury Secretary Jacob Lew said China "has committed to moving in an orderly way to a more market oriented exchange rate."

"It's important for China to stick to its reform agenda," Lew said. He added that the PBOC's communication last August "was not clear," according to Bloomberg News.

Puzzling aspect

One puzzling aspect is that the more recent depreciations appear to be just the opposite of the PBOC's position in its meetings with economists in March reported by The Wall Street Journal.

The confusion may be partly the result of mixed motives for driving the yuan up or down.

Economists seeking freer markets may argue that the yuan has become overvalued, while the interests of China's indebted state-owned enterprises (SOEs) cut both ways.

A cheaper yuan could boost exports, but it also makes dollar-denominated debt more costly.

The Journal cited an estimate by France's BNP Paribas that a 3-percent devaluation would add U.S. $25.6 billion (168 billion yuan) to the annual interest payments of Chinese companies.

Despite those concerns and SOE political pressures, the depreciation has been taking place.

"It's a very curious situation," said Gary Hufbauer, senior fellow at the Peterson Institute for International Economics in Washington. "There's no clarity."

"The markets are certainly perplexed by this," Hufbauer said in an interview.

Not the first time

The conflict with foreign media is not the first time that China has warned of possible legal action in defense of its exchange rate policies.

In January, the official Xinhua news agency threatened that "radical speculators" could face "potential legal consequences" following reports that international hedge funds had placed large bets against the yuan.

Some hedge fund managers were quoted as predicting a major devaluation of at least 10 and perhaps 20 percent, but the relative stability of the yuan in the following months had eased speculative pressures.

By the end of May, the yuan had dropped by 6 percent against the dollar since the currency reform last August, The Wall Street Journal reported separately.

The more recent pace of depreciation against the stronger dollar and uncertainty over PBOC policies may make the case that the hedge funds were right after all.

Either way, the controversy appears to be a setback for confidence in China's exchange rate management and reform plans.

"It takes China back from its announced goal of having a freely floating exchange rate and the yuan becoming an alternative to the dollar in world financial markets," Hufbauer said.

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Walt Peterson

from Boston

"It's a very curious situation," said Gary Hufbauer, senior fellow at the Peterson Institute for International Economics in Washington. "There's no clarity."

The conflict with foreign media is not the first time that China has warned of possible legal action in defense of its exchange rate policies.

Evidently, too much "clarity" is "destablizing." A little too much of that can get your Chinese correspondents hit with a lawsuit.

Jun 27, 2016 11:27 PM

Anonymous Reader

More lack of clarity from the SOE People's Bank of China, as might be expected from what is nothing other than a communist party-run state bank.

Jun 13, 2016 01:54 PM

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