A couple of weeks ago I suggested that China's exchange rate policy was in a serious bind, with a slowly depreciating exchange rate exacerbating capital outflow and foreign exchange reserves leaching away.
Since then, a monthly data release from China's central bank suggests China lost close to $100 billion during January. This suggests that the outflows are not accelerating but are still too large for comfort. The Chinese authorities can't wait until the accumulated reserve losses are substantial. Outward flows become stampedes well before that.
I suggested the authorities might consider a 10-15% depreciation, moving to a fixed rate against a basket of currencies, together with tightening of capital controls. Of course an explicit depreciation like this would annoy a lot of other countries, with mutterings of 'currency wars' and 'beggar-thy-neigbour', led by the US depreciation vigilantes who would add in 'currency manipulation' to the list of complaints. The IMF might also be miffed, as the Chinese have assured the IMF that there will not be a depreciation.
So here is an alternative but related idea that addresses the potential criticisms.
The Chinese authorities should announce a floating-rate framework in the form of 'band-basket-crawl' (BBC), a policy advocated more generally over the past few decades by well-respected exchange-rate expert John Williamson from the Peterson Institute. With BBC, the exchange rate is allowed to find its own level (ie. it is market-determined) within a band of, say, 10 or 15% either side of the initial rate. In the BBC framework, this band can 'crawl' (ie. change slowly over time) in response to changing underlying fundamentals, including inflation differentials vis-à-vis other currencies. If the market-determined rate reaches the edge of the band, the authorities would step in with market intervention to stop the rate from going outside the band.
In announcing the change, the authorities should explain that they believe the centre of the band is, in fact, somewhere around the medium-term fundamental equilibrium rate and provide the evidence to support this; mainly that China is running a substantial current account surplus, with exports growing well considering the weak world economy.
They could argue that China has not lost international competitiveness: instead it is going through the awkward transition of opening up its foreign exchange markets. [fold}
They could remind the market that, unlike the failed defences of fixed rates during the Asian crisis, China still has large foreign exchange reserves (and capital controls in place) and, unlike the UK in 1992, the authorities would have no political problem in putting up interest rates in defence of the renminbi if this proved necessary. They could explain that while their medium-term plan is for the band to crawl, given the current uncertainties in global markets, they would not allow the band to crawl until markets have re-established their poise. They need not say 'take us on at your own peril', but that should be the message.
Given China's current circumstances, it seems likely that the market rate would immediately fall to the bottom of the band (i.e. depreciate by 10 or 15%). This would make it even more likely that the newly depreciated rate would be internationally competitive, and harder to speculate against successfully. With the rate at the bottom band, the Chinese would be defending a rate which has already fallen below the IMF's assessment of the equilibrium, so there is a good probability of subsequent appreciation. Even for non-speculative capital outflow, the incentives to leave are reduced. This depreciation would be painful for some, especially the Chinese who have borrowed in dollars, and the authorities need to be ready to handle this.
A 10-15% band would also take out some insurance against the possibility that the market is right and the renminbi is in fact over-valued. After all, it has appreciated by 15% in real terms since 2013 (and 30% since 2010), partly as a result of the unremitting badgering of the US anti-manipulation vigilantes. These vigilantes will not apologise to China if things turn out badly. They applied similar pressure to Japan in 1985 (through the Plaza Accord), resulting in an over-appreciated yen, overly-low Japanese interest rates, the 1990 bubble and the ensuing lost decades.
Of course some foreign governments and commentators would still be annoyed, and perhaps also the IMF. But, really, what would they have to complain about? These same critics have been tireless advocates of floating rates and this is a bold step in the direction of a free float, with the band providing assurance that the tricky transition does not get out of control. It leaves open the possibility that later (much later) the band could be widened and ultimately removed, giving a free float. And it's not as if this framework is so radical. It's very close to the crawling band that Singapore has successfully had in place for decades.
China needs to address exchange rate concerns so it can clear the decks and concentrate on the central task of cleaning up the financial sector.
Photo courtesy of Flickr user faungg