Cooling down hot money: China widen Yuan trading band (Cont.)

In my last post, I talked about the recent headline on WSJ of China central bank engineered a depreciation of yuan against dollar, and then widen trading band for yuan from 1% to 2%. This unusual move has scared away investors that used to saw yuan as a safety nest. I also talked about the motivation for China to do so is counterintuitive—not to help exporter by depreciating yuan, but to shake out extra hot money that has irritated PBOC for the past few years. Now I would elaborate on why this is beneficial to China by shaking out hot money from the system and how it coincide with China’s other economic and financial reform.

According to the impossible trinity in international financial theory, it is impossible to have all three of the following at the same time:

Impossible_trinity_diagram.svg

1. A fixed exchange rate (In our case, we could roughly replace the term with managed floating exchange rate regime of China. You could view this regime in which the exchange rate is fixed in a small time span)

2. Free capital movement (Absence of capital controls.In China, legal capital investment are only limited to certain qualified foreign investors)

3. Independence of monetary policy.

In China, in order to maintain independence of monetary policy and relatively stable foreign exchange rate, China has to limit the free capital inflow. However, the balance has been breached since hot money flowing into China through unconventional channel. To maintain the exchange rate, China has been countering the upward pressure on Yuan caused by hot money inflow through intervening in the forex market, sucking up extra dollars and injecting into domestic market excess liquidity. The consequence is that China were forced to give up independence of monetary policy. PBOC would either be forced to rise interest rate to combat inflation and encourage consumption, or to leave inflation as is by holding interest rate level and encourage investment. What is more often the case is that the government would protect investment, since this is the leading contributor of Chinese GDP. Therefore more often we see inflation in China skyrocketing and real estate market bubbling. I lament for the vast and poor Chinese people that are facing an ever-increasing inflation.  No wander why consumption only accounts for a small fraction of GDP.

Fortunately, we are having at least some hope of seeing this end as Chinese leadership announced reformation. And the signal is a more liberalized forex market.

Widen of trading band is inline with the overall goal of creating a consumer-driven economy, rather than one that relies on exports or capital-intensive industries. By widen trading band, China is as if announced to the world that there will be no more free money, as Yuan could go either up or down with higher fluctuation. At the same time of international capital withdrawing, loosing hold on Yuan will help the PBOC focus more on domestic monetary policy while reducing the need for currency intervention. That is because as the yuan’s floating range gets bigger, it won’t touch the upper or lower limit of the band as frequently as it has, thereby lessening the central bank’s perceived need to meddle in the currency market.

As a result, the PBOC is expected to issue fewer yuan for the purpose of exchange-rate intervention, and that could alleviate inflation pressure. Consumption, would therefore be encouraged. And as hot money being shaking out of the market, real-estate price will also be more affordable for Chinese consumers. I hope that Chinese official will continue unwinding other economy reform that generate more long-term benefits and a sustainable growth.

5 thoughts on “Cooling down hot money: China widen Yuan trading band (Cont.)

  1. lippmanb

    I think that China’s goal of becoming more consumer driven is very important for its emergence as one of the top economies in the world. Some economists argue that consumption is the backbone of an economy. Considering how large China’s population is, it has the potential for a lot of output.

  2. nickcoll

    Its really interesting that China is stepping back and shifting away from its controversial currency manipulation. I wonder if there is any political reasoning behind China stopping its currency manipulation since the US and other developed economies always protested it.

  3. agolicz

    Thanks for sharing this really informative post, which pairs well with our lessons on international finance. Between this and your previous post on the yuan market I’ve learned a lot about China’s foreign exchange policies. I hadn’t realized the effect that China’s relatively fixed exchange rate policy would have on foreign investment inflows, especially into the real estate market, although it appears quite intuitive now.

  4. viczhou

    I do like the fact that you used the impossible trinity to analyze the PBOC’s decision. I agree that the central bank did not “manipulate” the recent move of the RMB in its traditional way criticized by foreign counterparts, because it aims to shake out speculators who have been continuously pouring hot money into China in anticipation of the RMB’s endless appreciation.

  5. dslavin

    An interesting thing to note about the short term effect of this policy change is that it has affected Chinese medium and small businesses negatively. Chinese banks were selling derivative products to these businesses and many of them have been hurt by the yuan’s drop in value.

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