For months now, China’s exchange-rate policy has been roiling global financial markets. More precisely, confusion about that policy has been roiling the markets. Chinese officials have done a poor job communicating their intentions, encouraging the belief that they don’t know what they’re doing.
But criticizing Chinese policy is easier than offering constructive advice. The fact is that China’s government no longer has any good options. No question, the country would be better off with a more flexible exchange rate that eliminated one-way bets for speculators and acted as an economic shock absorber. But the literature on “exit strategies” – on how to replace a currency peg with a more flexible exchange rate – makes clear that the moment when China could have navigated this transition smoothly has now passed.
Countries can exit a pegged rate smoothly only when there is confidence in the economy, encouraging the belief that the more flexible exchange rate can appreciate as well as weaken. This may have been true of China once; it is no longer true today.
This puts Chinese policymakers in the position of the Irish tourist who asks for directions to Dublin and is told, “Well, sir, if I were you, I wouldn’t start from here.”
What, then, is China’s least bad option? The authorities could continue with their current strategy of pegging the renminbi to a basket of foreign currencies, and push ahead with their agenda of restructuring and rebalancing the economy. But convincing skeptical observers that they are committed to this strategy will take time, given recent missteps. Meanwhile, investors will bet against them.
They already are. Capital outflows have been running at $100 billion a month. Simple arithmetic suggests that with $3 trillion of reserves, the authorities can hold out for at least a couple of years. But capital flight tends to rise dramatically as the end draws near. A two-year window is an illusion.
Alternatively, the renminbi could be allowed to fluctuate more freely. The People’s Bank of China can permit it to depreciate against the reference basket by, say, 1% a month, in order to enhance the competitiveness of Chinese exports and address concerns that the currency is overvalued.
But, given weak global demand, this kind of modest depreciation won’t do much to boost exports and support economic growth. Moreover, with the renminbi losing 1% of its value each month, capital flight would accelerate further.
A third option is a one-time devaluation of, say, 25%. This would enhance export competitiveness at a stroke. Depreciate the currency to the point where it is significantly undervalued, the argument goes, and investors will expect it to recover. Capital will then flow in, not out.
This assumes, of course, that everyone buys into the idea that one devaluation doesn’t augur another. It assumes that investors would be unperturbed by the authorities’ abandonment of their prior vow to shun a mega-devaluation. It ignores the fact that Chinese enterprises, already in dire straits, have as much as $1 trillion of foreign-currency debt that would become significantly more difficult to service. And it minimizes the devastating economic impact of a mega-devaluation on countries with which China competes.
By process of elimination, the only option that remains is tightening capital controls. Strict controls can prevent residents and foreigners from selling renminbi for foreign currency on onshore markets and transferring the proceeds abroad.
Protected by this financial Great Wall, the authorities could let the exchange rate fluctuate more freely and allow it to depreciate gradually without provoking capital flight. They would gain the time needed to implement confidence-building reforms. They could curtail the provision of liquidity to loss-making enterprises, forcing firms to eliminate excess capacity. They could restructure problematic debts. They could recapitalize banks that suffered inadvertent balance-sheets damage as a result of these reforms. They could repair their damaged credibility.
A few observers, like Bank of Japan head Haruhiko Kuroda, have suggested that China might consider tightening controls. But most economists are reluctant to contemplate this option. Capital controls would undermine China’s efforts to internationalize the renminbi and would embarrass the International Monetary Fund, which recently added the currency to the basket of four major currencies underpinning its unit of account, the SDR.
The most powerful objection, though, is that reimposing controls would remove the pressure to reform. Freed of pressure from international capital markets, the Chinese authorities would defer to state-owned enterprises and local officials who prefer continued easy provision of liquidity and would rather see the banks simply roll over their loans.
This risk of backsliding is real. If it materializes, the time bought by capital controls will be squandered. The problem would then metastasize, at some point, from an exchange-rate crisis to a growth collapse. China’s best hope – and the world’s – is that the Chinese authorities understand that a crisis is a terrible thing to waste.