The Renminbi and Beijing’s ‘Chi-Lemma’

Citi GPS Opinion Article

24 March 2014 – Currency dilemmas are familiar territory for policymakers in emerging markets. The best known of them is the ‘Tri-lemma’, the idea that a country can’t have both a fixed exchange rate and independent monetary policy in a world of globalized capital flows. The recent volatility of the Renminbi (RMB) raises the question of whether China has a dilemma of its very own: a ‘Chi-lemma’, in which Chinese policymakers struggle to balance a stable exchange rate and strong growth without exposing themselves to the risks that come from excessive speculative capital flows. Put another way: is a stable RMB necessary to support Chinese growth?

A stable currency has suited China…
The RMB has been on a path of steady, predictable appreciation since 2005, except for a two-year pause that was introduced in 2008 as the financial crisis gathered pace in the North Atlantic. A steadily appreciating currency has served two objectives. In the first place, it has helped to support China’s efforts – mostly unsuccessful – to rebalance the economy away from investment spending and towards consumer spending. Exchange rate appreciation should help here by supporting the international purchasing power of Chinese households.

And the second objective that’s been served by steady currency appreciation is the internationalisation of the RMB. Since China has neither deep, liquid capital markets, or an internationally accessed legal system, it doesn’t really possess the full set of prerequisites for an international currency that exist, say, in the US or the Eurozone. But a stable exchange rate has provided a way of increasing the RMB’s trustworthiness as an international unit of account and store of value. And China has enjoyed some success here: some 15% of Chinese trade is now settled in RMB; and it is now the 11th most used currency in SWIFT (though its market share is still less than 1%, compared to 36% for both the USD and EUR). And the world’s central banks, eager to diversify their reserves holdings, have dipped their toes into the RMB.

…but has attracted speculative inflows
Yet the steady appreciation of the RMB in recent years has not been without cost. The most visible cost is that China has become a magnet for speculative capital inflows. These flows seemed to grow dramatically during late 2012, 2013 and early this year, a growth that was reflected in the strength of the CNY within its trading band; and in the premium at which the offshore CNH traded against on the onshore CNY.

But capital inflows seeking to establish un-hedged currency positions in the RMB go back further than this. During the post-Lehman era of exceptionally low US interest rates, the predictability of the RMB has attracted inflows. According to BIS data, cross-border bank lending to China increased by $620 billion between early 2009 and late 2013, the vast bulk of which was lent at maturities of one year or less. The working assumption has to be that a reasonable amount of this exposure was aimed at creating un-hedged currency positions that are ‘long’ RMB, ‘short’ USD. During the same period, around $230 billion of securities were issued by Chinese borrowers, some of whom will have been motivated by the same desire.

A big wave of speculative capital inflows is unpleasant for any country – primarily because it can be the prelude to an even more unpleasant wave of speculative outflows. For this reason, the Chinese authorities have considered for some time the idea of making the RMB less of a one-way bet, and to erode the incentives for speculative positions in the currency. That’s the main objective behind the PBOC’s efforts since mid-January to weaken the CNY fixing rate, and its mid-March decision to widen the CNY’s daily trading band to +/- 2% from +/-1%. Complementary measures might include the introduction of taxes on various kinds of borrowing, in an effort to throw ‘sand in the wheels’ of speculative activity; and new measures to facilitate capital outflows. These might not be needed though, if volatility by itself breeds outflows.

So, the need to cut down on speculative inflows argues strongly in favour of introducing some two-way risk for the RMB. But: at what cost?

Ending the RMB’s ‘one way bet’ has a cost
One big advantage of large capital inflows into China is that they have helped to lubricate the engine of China’s credit-driven growth model. As long as inflows have been plentiful, it’s been easy for the PBOC to finance the creation of domestic liquidity: it buys the dollars that are coming in, and sells RMB. Of course that’s not the only way the PBOC can create liquidity: the required reserves ratio (RRR) of Chinese banks is very high, for example, and cutting this could be a new source of domestic liquidity. But it is common enough for emerging economies to see weaker domestic liquidity conditions when capital flows out rather than in. And in China too: when ‘tapering risk’ first began to suck capital out of emerging markets last May, large outflows from China helped to set the stage for a nasty liquidity crunch in June 2013.

Capital outflows are not naturally conducive to strong domestic credit creation, and that might raise concern about GDP growth in an economy that has been as credit-hungry as China’s has been in the past five years. So, one element of the ‘Chi-lemma’ will be to make sure that more exchange rate volatility doesn’t come at the expense of a sudden slowdown in credit growth that could squeeze the economy. That challenge will be particularly difficult at a time when the front end of the US yield curve might shift up in the next few months: rising short term interest rates in the US might erode banks’ willingness to roll over their cross-border loans to borrowers in China, especially when there is more uncertainty about the path of the exchange rate.

Worries about growth or capital inflows might limit the RMB’s volatility
Another element of the ‘Chi-lemma’ is this: how can China continue to increase the RMB’s trustworthiness as an international currency when the exchange rate becomes less predictable? The answer is easy in principle. Exchange rate predictability is not a reliable underpinning for an international currency; it needs to be backed up by deep markets and strong institutions. So financial liberalisation and an opening of the capital account will be needed to shore up the RMB’s attractiveness now that the days of the one-way bet are past. Chinese policymakers seem committed to this. But liberalising the capital account will be a tough challenge for China when the direction of flows is likely to be outwards rather than inwards.

All in all, the question ‘what to do with the RMB?’ looks like it will add to the challenges facing Chinese policymakers as they manage the inevitable transition towards slower growth. Although they have made a bid to end the RMB’s ‘one-way bet’, there will be limits as to how far they can go: the ‘Chi-lemma’ means that too much exchange rate volatility could be bad for growth.