Risks Under Control

Risks Under Control

The People’s Bank of China, the central bank, widened the trading band for the yuan against the U.S. dollar in April. Now questions about the potential risks facing a more flexible yuan have arisen, most importantly: Are these risks controllable? Mei Xinyu, an associate researcher at the Chinese Academy of International Trade and Economic Cooperation of the Ministry of Commerce, addressed this issue in an article to Beijing Review. Edited excerpts follow:

Enhancing flexibility of the yuan’s exchange rate formation mechanism and realizing the yuan’s free fluctuation to a large extent have been a long-term goal for the Chinese Government. But the potential risks of increasing exchange rate flexibility should never be overlooked.

History has proven to us that countries with a floating exchange rate have a bigger chance to be hit by financial crises than those with a fixed exchange rate. Moreover, enhanced flexibility of the exchange rate brought by international speculative “hot money” is more harmful for developing countries.

High flexibility can have an extremely adverse effect on the financial market of developing countries, because the value of financial assets denominated in the local currency that residents hold will also fluctuate and residents may turn to assets denominated in foreign currencies. Then, the domestic financial market denominated in the local currency will shrink.

Because of the hidden risks, countries with a floating exchange rate regime have little chance to succeed. China is cautious as it widens the yuan-U.S. dollar trading band, hoping to minimize the side effects of the move.

On April 16, the People’s Bank of China widened the trading band for the yuan against the U.S. dollar to 1 percent from 0.5 percent, the latest move after the trading band was widened from 0.3 percent to 0.5 percent in 2007.

Can we control the risks of increased yuan exchange rate flexibility this time? The answer should be yes.

Ripe conditions

If the yuan’s one-way fluctuation (only appreciation or only depreciation) expectation prevails in the foreign exchange market, increasing exchange rate flexibility will make the rate unstable. China didn’t dare to rashly widen the trading band in the previous years because both the trend of foreign exchange market and the people’s expectations are on the yuan’s appreciation.

The central parity for the yuan against the U.S. dollar has appreciated over 30 percent, since China unpegged the yuan to the U.S. dollar and shifted to a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies in July 21, 2005.

Only when the yuan’s exchange rate sees two-way movements can the widening of the trade band avoid causing drastic fluctuation, especially substantial appreciation in the short run which is beyond the endurance ability of China’s real economic entities.

In a large country like China, all economic moves in the past, at present and in the future have to rely on its strong real economy.

The good news is that the yuan’s one-way fluctuation came to an end in 2011. The currency’s two-way fluctuation was thoroughly demonstrated in December 2011 and the first four months of 2012.

Among the 19 trading days from December 6 to the end of 2011, there were eight trading days when the yuan depreciated against the U.S. dollar. From the beginning of 2012 to April 20, half of the 70 trading days saw the yuan depreciated against the U.S. dollar.

From December 30, 2011 to April 20, 2012, the yuan slipped 0.05 percent against the U.S. dollar. The Chinese currency has virtually realized two-way fluctuation.

The two-way fluctuation of the yuan’s exchange rate will continue throughout the whole year and become a more common phenomenon, due to the changing balance of China’s foreign trade and dramatic fluctuation in emerging economies.

Dwindling trade surplus

Export increase and continuous trade surplus used to back the yuan’s appreciation. So de-clining exports and trade deficit would do the contrary.

TRADE DEFICIT: A container port in Lianyungang, east China’s Jiangsu Province. According to the General Administration of Customs, a trade deficit of $31.48 billion appeared in February, the largest monthly deficit in a decade

In January 2012, China witnessed drops both in imports and exports, which has been rarely seen in the past several years. Their total value was $272.6 billion, a 7.8-percent year-on-year decrease. Exports dropped 0.5 percent to $149.94 billion and imports declined 15.3 percent to $122.66 billion. Although exports and imports both saw yearon-year increases in February, a trade deficit of $31.48 billion appeared, the largest monthly deficit in a decade.

The large monthly trade deficit caused depreciation of the yuan exchange rate in the foreign exchange market. On March 12, the central parity of the yuan against the U.S. dollar nosedived 209 basis points, the largest drop in one trading day for the past one and a half years.

The lingering subprime crisis and sovereign debt crisis that developed countries and regions are mired in have hindered their ability to import from China. In 2011, China’s exports to the European Union, United States and Canada increased 14.4 percent, 14.5 percent and 13.7 percent, respectively, all lower than China’s overall export growth in the year, which stood at 20.3 percent.

Developed countries and regions are our traditional export markets. Although it’s estimated that China can gain surplus for the whole year of 2012, more monthly deficits may appear. Under this circumstance, the yuan’s appreciation trend can be frequently interrupted by the changing balance of foreign trade or can even be reversed.

Emerging economies

Unstable macroeconomic situations in emerging markets will intensify the fluctuation of the yuan exchange rate, via the international financial market. Economic fundamentals, market trends of primary products and increased capital liquidity will jointly produce drastic fluctuations in economic growth and currency exchange rates in emerging markets.

Almost all emerging economies, except China, witnessed two-digit depreciation of their currencies against the U.S. dollar in 2011, such as Russia, Brazil, India and South Africa. The depreciation of their currency exchange rates is closely related to their economic fundamentals.

Take India for instance. Continuous current account deficits for several decades after its independence caused the depreciation of the rupee in 2011. Also, India imports about 75 percent of its energy, giving the country enormous pressure for imported inflation. India’s monetary authorities had to continue tight monetary policy to hedge inflation, leading to the longest period of interest rate hikes in its history, which has brought further damage to the real economy and made the rupee depreciate even more. Rubbing salt into wounds is capital fleeing the country.

Although $7.4 billion made its way into the Indian stock market by early March, pushing up the SENSEX index of the Bombay Stock Exchange by 11 percent, the basic economic regime in the country hasn’t been utterly changed. The exchange rate increase and capital backflow in India in the previous two months are not stable and the situation can be easily reversed. By then, the more capital has flown back, the severer the impact will be when the capital flows out.

Emerging economies’ prosperity in recent years partially stems from the boom of the commodities market. However, the primary goods have seen obvious price decreases, with the Thomson Reuters/Jefferies CRB Index plunging 8.3 percent in 2011. It’s estimated that the import prices of commodities in 2012 will continue to drop, giving more pressure to emerging economies.

Hence, economic growth rates and exchange rates in emerging economies will see further intense fluctuations this year, which will increase the possibility of the two-way fluctuation of yuan exchange rate.