But then the RMB fell unexpectedly, hitting the bottom of the daily trading band set by the Peoples’ Bank of China (PBoC) for 11 sessions in a row. Though the RMB has since returned to its previous trajectory of slow appreciation, the episode may have signaled a permanent change in the pattern of the exchange rate’s movement.
As long as China was running a trade surplus and receiving net inflows of foreign direct investment, the RMB remained under upward pressure. Short-term capital flows had little impact on the direction of the RMB’s exchange rate. There were two reasons for this. First, thanks to an effective – albeit porous – capital-control regime in China, short-term “hot money” (capital coming into China aimed at arbitrage, rent-seeking, and speculation) could not enter (and then leave) freely and swiftly. Second, short-term capital flows usually would strengthen rather than weaken upward pressure on the RMB’s exchange rate, because speculators, persuaded by China’s gradual approach to revaluation, bet on appreciation. So why, if China was still running a decent current-account surplus and a long-term capital surplus, did the RMB suddenly depreciate, forcing the PBoC to intervene (though not very vigorously) to prevent it from falling further? Many economists outside of China have argued that the December depreciation resulted from betting by investors that Chinese policymakers, facing the prospect of a hard landing for the economy, would slow or halt currency appreciation. But if that were true, we would now be seeing significant long-term capital outflows and heavy selling of RMB for dollars in China’s foreign-exchange market. We see neither reaction. More importantly, the RMB’s slow appreciation resumed fairly promptly after December’s dip, while investors’ bearish sentiments about China’s economy remain consistent.
In fact, the RMB’s sudden fall in December reflects China’s liberalization of cross-border capital flows. That process began in April 2009, when China launched the pilot RMB Trade Settlement Scheme (RTSS), which enables enterprises, especially larger ones, to channel their funds between Mainland China and Hong Kong. As a result, an offshore RMB market, known as the CNH market, was created in Hong Kong alongside the onshore market, now dubbed the CNY market. But, in contrast to the CNY, the CNH is a free market. Given expectations of RMB appreciation and a positive interest-rate spread between Mainland China and Hong Kong, the RMB had a higher value in dollar terms on the CNH than on the CNY market. That difference led to active exchange-rate arbitrage by mainland importers and multinational firms – one form of capital inflows from Hong Kong to the mainland. Correspondingly, RMB liabilities owed by mainland Chinese and multinationals increased, as did RMB assets held by Hong Kong residents. Exchange-rate arbitrage by mainland importers and multinationals creates upward pressure on the CNY and downward pressure on the CNH. In an economy with flexible interest and exchange rates, arbitrage eliminates the exchange-rate spread quickly. But, because China’s exchange rate and interest rates are inflexible, the CNH-CNY spread persists, and arbitragers are able to reap fat profits at the economy’s expense. Last September, however, financial conditions changed suddenly in Hong Kong. The liquidity shortage caused by the European sovereign debt-crisis led developed countries’ banks – especially European banks with exposure in Hong Kong – to withdraw their funds, taking dollars with them. As a result, the CNH fell against the dollar. At the same time, the shortage of dollars had not yet affected the CNY, which remained relatively stable. The CNH therefore became cheaper than the CNY. Consequently, mainland importers and multinationals stopped buying dollars from the CNH market and returned to the CNY market. At the same time, mainland exporters stopped selling dollars in the CNY market and turned to the CNH market. The dollar shortage created depreciation pressures on the CNY, which the PBoC declined to offset. The CNY was thus bound to fall, which it did last September. Reverse arbitrage meant capital outflows from the Chinese mainland. Correspondingly, RMB liabilities owed by mainlanders and multinationals decreased, as did RMB assets held in Hong Kong. In fact, increases in financing costs and uncertainty about RMB appreciation prompted a partial sell-off of RMB assets by Hong Kong residents. In short, because the RTSS made cross-border capital movements much easier, short-term flows have become a major factor in determining the RMB’s exchange rate. External shocks affect the offshore exchange rate first, and then feed through to the onshore exchange rate. The RMB will continue to appreciate in the near future, owing to strong economic fundamentals, but the inherent instability of short-term capital flows will make its exchange rate more volatile. This change is bound to pose new challenges for decision makers in the United States and China, particularly as they engage in a fresh round of debate about China’s exchange-rate policy.
Yu Yongding, president of the China Society of World Economics, is a former member of the monetary policy committee of the Peoples’ Bank of China and former director of the Chinese Academy of Sciences Institute of World Economics and Politics. © Project Syndicate 2012