To reform or not to reform: That is the question in China these days. The country is weighing a key decision over whether to simply loosen restrictions on its highly controlled capital account, or to make the yuan, also known as the renminbi (RMB), or “people’s money,” a fully convertible international currency.

Beijing’s dilemma over whether to accelerate the slow evolution toward full convertibility sharpened in August when the government devalued the yuan by almost 2%, catching the markets by surprise. That move unleashed a spate of turbulence that has yet to fully subside, and the most recent bout of acute volatility has accentuated concerns over China’s economic slowdown and its global repercussions. The confusion and anxiety are compounding as capital flows out of China, straining Beijing’s capacity to control the yuan’s value.

The 1.5% drop in the yuan’s value against the U.S. dollar in early January, to its lowest level in five years, reinforced suspicions that China might be opting to devalue the yuan — long overvalued in many economists’ estimation — to breathe some life into its export sector. Economists say Beijing has been failing to communicate its intentions effectively to investors and markets in the wake of the People’s Bank of China’s (PBOC) decision to cut its daily reference rate by 1.9%, triggering the yuan’s biggest one-day drop since China ended its dual currency system in January 1994. The PBOC China called the change a one-time adjustment and said it would better align the yuan with supply and demand.

Seeking to calm the markets and stem capital outflows that have picked up in recent months, on December 11, the PBOC issued a notice that the yuan’s value should be viewed in terms of a trade-weighted basket of currencies rather than just the dollar. That has in fact been the policy for years. However, that step just convinced investors and markets that the central bank was trying to weaken the yuan against the U.S. dollar and other currencies. China’s foreign exchange reserves dropped by a record $108 billion in December and declined by $99.5 billion in January.

Whatever the markets’ perceptions, what China did twice was to move toward greater exchange rate flexibility in keeping with its goal of making the yuan an international currency, says Louis Kuijs, head of Asia Economics at Oxford Economics. “What happened in August and December were moves by the PBOC to relinquish that link with the U.S. dollar and to make the first step toward eventual exchange rate flexibility. The first step that was recommended by many experts was to focus on the basket of currencies instead of focusing on the U.S. dollar,” Kuijs says. “They have tried to focus everybody’s attention more on the basket and keep on telling the market that we have move to focus on the basket rather than the bilateral link with the dollar.”

[drizzle]Opaqueness vs. Transparency

Much of the problem stems from a lack of transparency that is typical of China’s policymaking, since in reality the PBOC did not say explicitly that those were its motives and that in turn damaged its credibility at a time when investors were already worried about the possibility China might devalue.

“They are saying that we are not targeting this or that and they are saying there is no reason the RMB depreciates significantly against the basket,” Kuijs says. Since Chinese leaders have continued to claim they have no intention of weakening the yuan while taking steps that lead directly to that outcome, the market is “not buying or not completely believing what the policymakers are saying.”

The market is “not buying or not completely believing what the policymakers are saying.”–Louis Kuijs

Pieter Bottelier, an adjunct professor of China studies at Johns Hopkins School of Advanced International Studies (SAIS) in Washington, D.C., agrees. “They did not communicate with the market what was the background to, and the intention of, the August 11 policy and the December 11 valuation change,” Bottelier says. “There is a serious problem with the way they explained this to investors, especially to international markets they have been poor in communicating their objectives and intentions.” Bottelier views the intention of seeking stability of the yuan against the trade-weighted basket as an “essentially right policy change, but it was poorly explained.”

So far, those policy shifts appear to have backfired: Expectations of a weakening yuan led to bigger capital outflows as investors shifted their money elsewhere in hopes of protecting their returns, and capital outflows further weaken the currency, a trend that is spreading into other emerging markets. “Recent days saw a large depreciation against the U.S. dollar of all Asian exchange rates except the Japanese yen, with the [South Korean] won down 2% and the Malaysian ringit and New Zealand dollar down almost 3%, and the Australian dollar more than 3%,” Kuijs said in a report issued January 7. Brazil’s real and the Russian ruble also weakened more than 1%.

Economists and forex specialists say the further weakening of the yuan against the dollar would trigger further weakening of emerging market currencies, including weakening of other Asian currencies that could lead to a possible currency war. The Japanese yen is less affected because of the Bank of Japan’s latest monetary easing and the newly effective negative interest rate has not so far led to depreciation. Though the Bank of Japan may intervene or carry out additional easing, many economists are forecasting that the yen might strengthen rather than fall, regardless of the yuan’s movements against the dollar.

Alvin Tan, forex strategist of Societe Generale Cross Asset Research, wrote in a February 1 report titled, “Strategies for a CNY 7.5 World,” which compiles comments by more than 20 Societe Generale analysts and economists, that if the yen-dollar rate drops to 110 yen under the risk scenario of a 7.5 yuan rate to the dollar, a 14% weakening of the yuan, Japanese policymakers may intervene. So the Japanese yen’s rate is likely to be limited to 110 yen against the dollar.

In the same report, Jason Daw, head of Asian forex strategy at Societe Generale Cross Asset Research, wrote that under the risk scenario target of 7.5 yuan, a 14% increase in the U.S. dollar against the yuan would cause Asian currencies to weaken between 6% to 16%: the Korean won by 16%; the Malaysian ringit by 16%; the Indonesian rupiah by 15%; and the Indian rupee by 14%.

Role of the IMF

More generally for China, the irony is that another motivation behind China’s policy change in August was to have the yuan included in the International Monetary Fund’s SDR (special drawing rights) currency basket. SDRs are an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves, but the SDR basket does not play as important a role today as it did in the past when the Bretton Woods system was in place. The yuan’s inclusion in the basket means that the IMF believes that China’s currency has a global standing on a par with the other four currencies in the basket — the U.S. dollar, the euro, the pound and the yen.

The IMF did finally decide in late November to include the yuan in the SDR basket as an international currency. The recognition of the yuan as a reserve currency reflects its growing importance in world trade, but is mainly of symbolic importance, says Rajiv Biswas, a Singapore-based Asia-Pacific economist at IHS Economics. Given the amount of pain suffered as a result of the recognition, “I do not think it was a good idea,” Biswas says. “Trying

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