Currency Concerns Under Uncertainty: The Case of China

Sunanda Sen, Guest Blogger

Concerns have been rising, in recent months, over the current state of China’s external balance and the future of the RMB. Apprehensions relate to the negative balances, which have been visible in China’s financial balance since the last quarter of 2011. The negative sums were respectively (-) $ 3.02 and  (-)$ 4.21 billion during the second and third quarters of 2012, preceded by an even larger sum at (-)$ 29.0 billion in Q4 2011. Such deficits contrast with the surpluses in the financial account usually maintained, which were as much as $13.20 billion during Q4 of 2010.  These changes have been matched by tendencies for its official reserves to slide downwards. For instance, there was a $ 6 trillion drop in official reserves between March and June 2012. Pressures on the RMB rate even led to its depreciation, from 6.30 per dollar in April 2012 to 6.41 by August 2012. The currency, however, reverted to its earlier phase of appreciation, with the rate moving up from RMB 6.38 to RMB 6.31 between 24th July 2012 and 18th January 2013.

Differences relating to the exchange rate have continued to prevail across officials and think tanks in China and the US, with the latter holding China’s exchange rate management responsible for the continuing global account imbalances between the two countries. With pressures on China to appreciate the currency, the US Treasury even came to the point on in April 2010 of deciding whether China can be treated as a currency manipulator. The on-going dynamics of China’s foreign exchange transactions can be better understood by tracking the following major breaks in China’s exchange rate policy:

First, an end to the prevailing fixed RMB-dollar rate in 2005, which came largely with pressures from the US. Despite the twin surpluses between the current and the capital account, China was maintaining, since 1997, a fixed exchange rate at around 8.27 RMB per dollar. The change to managed floating, still supported by direct purchases of foreign currency which were flowing in abundance with the twin surpluses, led the RMB to rise immediately to 8.11 per dollar, with gradual appreciations since then. With appreciations continuing, the change to a floating RMB did not, however, lead to currency speculation till the third quarter of 2011.

The second break in China’s currency management came as foreign currency began to be privately held in 2007. With RMB continuing to appreciate, those private holdings did not immediately affect the ongoing appreciations of the RMB in the market. However, with rapid domestic growth and expectations of further appreciations, the measure did not lead to currency speculation and outflows (This came later as expectations of possible depreciation started building up, in turn signaled by the shift in currency management along with downturns in the financial account, which came in the third quarter of 2011.)

The above relates to the third break in China’s currency policy in September 2011 with the “advent of RMB’s two-way floating process.” A moderate drop in trade surplus and in the financial account balance of China by the third quarter of 2011 led the PBoC to allow a “two-way float” in the foreign exchange market, thus ending a long-standing consensus of a unidirectional movement of the renminbi rate which prevailed until then.

The measure, in principle, permitted the currency to depreciate for the first time. However, the “two-way floating” of the currency did not automatically reverse the upward movements in RMB, which continued appreciating, though at a slower rate. Simultaneously the rise in reserves and direct purchase of foreign exchange by the state also has continued, with reserves currently well above $3billion.

Fourth, currency management was subject to further changes in China by April 2012 when the daily trading limit of the currency against dollar officially widened from 0.5% to 1%. The measure, while allowed the rate to move in either direction, would, as held by Chinese experts, also encourage wider use of the currency in international markets.

Analyzing further, the changed regime under “two-way floating “ and related downslides in the financial account can be related to the speculative tendencies in China’s currency markets. Betting on a possible depreciation of the currency which was backed up by deteriorations in the country’s financial account, the official announcements in September 2011 for “two-way floating” brought in sharp changes in the state of expectations in the foreign exchange market.)

Above, as viewed by us, is capable of bringing about further reversals in China’s flow of external payments with resulting repercussions on the exchange rate.  However, sentiments as mentioned above relating to an undervalued RMB seem to have temporarily petered out in recent times and  appreciations in the RMB rate have come back, though at a decelerated pace. Thus after depreciating between April 2012 and August of 2012 from 6.30 to 6.41 per dollar, the rate later moved up, from RMB 6.38 to RMB 6.31 between 24th July 2012 and 18th January 2013.

Announcements of the “two-way floating” of the RMB with the possible losses, as were expected by holding a depreciating currency, affected the structure of China’s external payments. The matter opens up further concerns about the sustainability of the prevailing pattern of China’s economic transactions in the global economy.

Looking at recent changes in such transactions, we notice that while China’s trade surplus has hardly changed much, other than a moderate dip in Q4 2011, which was followed by recoveries to even higher levels by Q2 and Q3 of 2012. However, net investment income, including reinvested earnings, showed a larger negative net flow by Q2 of 2012. The above can be explained by incentives on part of foreign corporates to remit abroad their foreign currency earnings due to possible depreciation of the RMB.

Next we try to explain the unprecedented negative financial balances at $ 3.02 billion and $ 4.21 billion respectively by Q2 2012 and Q3 2012, in contrast to the $13.20 billion surpluses earlier during Q4 of 2010. This by itself raises a new set of concerns. One can mention a jump in net portfolio asset inflows, a rise in trade credits advanced against China’s imports, increases in foreign currency loans advanced and withdrawals of foreign currency (mostly dollar) from Chinese banks. All of these came with expectations of a depreciating RMB. All of the above can be identified from China’s BoP accounts.

Changes in China’s external payments in relation to changing expectations, reminds us of the need for the re-regulations that arise with destabilising expectations and rising uncertainty, which is not one of a piece with perfect information. As formulated by Keynes in 1936 with the publication of The General Theory, “About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.”

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