As of yesterday, the Yuan fell to its lowest value relative to the dollar in ten months because the Chinese government “doubled the currency’s daily trading range” over the weekend. With the goal of reducing capital inflow so as to decrease the risk of asset bubbles, this policy is part of China’s plan to replace strict currency controls with financial regulation. Ultimately, China hopes to achieve greater financial stability in doing so.
Personally, I find this rhetoric hard to believe. We learned in class that China benefits from reduced capital inflows. Reduced capital inflows imply an increase in net capital outflows, which in turn leads to a boost in China’s net exports, a depreciation of the Yuan, and an increase in GDP. For this reason, it seems hard to believe that China is committed to loosening currency controls.
This wishy-washy policy is what places China in “banking purgatory.” By directly impacting financial institutions and private banking, China’s inconstancy places it in an awkward purgatory between fully controlled markets (economic Hell) and capitalism (economic Heaven – obviously my opinions are made very clear here…).
Specifically, China’s wishy-washy policy impacts banking and financial institutions in the following way: given China’s commitment to decreased currency manipulation, many private firms in China (both financial and non-financial) have already pursued billions of dollars worth of options contracts to hedge against an appreciating Yuan. That said, when the government steps in and redirects changes in the Yuan’s value, these options generate losses for private firms. In 2014, the Yuan is down 2% relative to the dollar, and this depreciation has resulted in over $2 billion of losses for Chines firms.
For Chinese firms making exportable goods, the losses on these options are minimized by a boost in exports. However, financial firms, which do not usually export any tangible goods, are not so fortunate. Given the already unstable state that Chinese financial firms are in (the government is just beginning to warm up to private banking), these losses could have significant implications for shadow banking.
China’s currently uses a public banking system. This policy has ultimately hurt small businesses, as it is harder for them to meet the strict borrowing requirements set out by a highly risk-averse institution like the Chinese government. Unable to qualify for public loans, small business turn to shadow banks instead, which force many small businesses into unaffordable loans (shadow banks are financial intermediaries that carry out typical banking activities like commercial lending, but without the limits of traditional depository regulations).
Because China’s small businesses cannot qualify for public loans and cannot afford shadow loans, they are left with very few options for sustainable growth. Given that small businesses in China are responsible for 60% of China’s GDP and 75% of China’s new jobs, this predicament poses a serious threat to China’s economic sustainability. A simple solution would be to allow for private, regulated, banking. And in the beginning of 2014, China did just this, approving a pilot plan for the establishment of 3-5 private banks. That said, given the losses that Chinese financial firms are experiencing currently (caused by the government’s currency manipulation), I find it unlikely that the proliferation of private banking will come anytime soon.
In this way, China is stuck in an uncomfortable middle ground on its way to economic deregulation; like the Catholic destined for heaven but in need of purification, China is struggling in purgatory as it develops into a capitalist economy. While China has committed verbally to currency deregulation (a very good step in my opinion), the country’s policies do not yet align with this verbal commitment. Certainly, it is difficult for a country as big as China to abandon such an engrained tradition of currency manipulation. But until China commits to doing so, inconsistent policy will plague financial institutions, which will in turn reduce the chances of successful private banking and increase the pain small businesses feel from shadow banking. Complete commitment to looser currency controls is therefore necessary for China to escape its banking purgatory and fuel sustainable, long-run growth.