(Revised Cont.)China widen yuan’s trading band: a signal for economic overhaul

In my last post, I talked about the recent news on WSJ that 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 see 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 hot money that has been irritating 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 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 view China as implementing fixed exchange rate regime, where the rate is managed to move within 1% for a short time span.)

2. Free capital movement (Investing in Chinese capital market is exclusive to limited amount of qualified foreign institutional investors)

3. Independence of monetary policy.

Historically, China has given up free capital movement in order to maintain independence of monetary policy and relatively stable exchange rate. However, the balance was breached since 2008, as hot money flowing into China through unconventional channel. Predictably, China had to give up either independent monetary policy or exchange rate manipulation.

The consequence is that China was forced to give up independence of monetary policy.  In countering the upward pressure on Yuan caused by hot money inflow, PBOC intervened in the Forex market, sucking up extra dollars and injecting excess liquidity into domestic economy. As a result, inflation rises. PBOC could either raise interest rate to combat inflation and protect consumption, hold interest rate as is and protect investment. What to do, what to do, here is what China do. The government would protect investment, given the larger contribution of investment to GDP. Therefore more often we see inflation skyrocketing and housing price soaring. 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 towards a more liberalized Forex market.

Widen trading band is inline with the ultimate goal of creating a consumption-driven economy, rather than exports or investment driving. By widen trading band, China was as if announcing that hot money will no longer be safe here, because Yuan could go either up or down with higher fluctuation. As hot money withdrawing, loosing hold on Yuan will help PBOC focusing more on domestic monetary policy. PBOC will also reduce the need for currency intervention, 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 exchange-rate intervention, and that could alleviate inflation pressure. I hope that Chinese official will continue unwinding other economy reform that generates more long-term benefits and a sustainable growth.