Hot Money and the Renminbi

Now that we’ve had a week and a half to see China’s new exchange rate regime in action, several features of the new regime are becoming clearer. First, while the political ramifications of the move seem clever – the PBoC took a bit of the steam out of the protectionist sentiments on the floor of the US Congress, and it marked the first time that other Asian currencies (the Yen, Won and Ringgit, for example) moved in response to Chinese monetary policy changes – the long-term economic implications seem less benign.

First, China has, in theory at least, now broken its hard peg to the dollar and moved to a “managed float.” Notwithstanding the fact that in practice the managed float looks a lot like the previous hard peg (the Chinese only allowed a 2.1% appreciation against the dollar after all, and seem disinclined to tolerate much further appreciation), managed floats are inherently unstable beasts because of the change in sentiment they promote in the financial markets.

Since the 2.1% revaluation amounted to a good deal less of an appreciation than the markets would have liked (10%-20%), expectations of continued, gradual appreciations are now building. Part of the problem was the PBoC’s initial press release, which suggested that the renminbi would be allowed to trade within a .3% band against the dollar, and that the next day’s spot rate would be based on the previous days’ closing price. Without intervention in the foreign exchange markets by the PBoC, traders would have pushed the renminbi to the limit of its .3% band every day. Yet from an initial new spot rate of 8.11 to the dollar, the renminbi closed on Friday at 8.1056.

Still, the main sentiment that has now taken hold in the markets, and indeed the main feature of managed float exchange rate regimes, is uncertainty. How high will the PBoC let the renminbi go? On Monday it closed at 8.1046 to the dollar, a .07% increase from the July 21 revaluation. The fact that the PBoC has not revealed the contents of the basket of currencies against which the renminbi’s exchange rates are now set has added to the confusion.

Now the question on everyone’s mind is whether or not “hot money” will flow into China betting on further appreciation, causing further problems for the Chinese. Survived Sars, a China blog I just recently discovered, has some good analysis of this and other issues related to the renminbi and Chinese public policy generally, so go have a look. The Chinese have not removed their capital controls, so going long on the renminbi is no simple bet to make. That said, there are ways around the lack of currency convertibility, and everyone from hedge funds to overseas Chinese to corporate exporters and importers are said to be bringing speculative investments into China. There’s not a lot of hard data to back these claims up, but see Brad Setser’s explanation of Chinese investment flows.

If the PBoC is forced to conduct large and sustained interventions in the foreign exchange markets to keep the renminbi stable, their ability to sterilize these foreign exchange purchases through the issuance of domestic renminbi denominated debt will steadily decrease. Through July 4, 2005, the Chinese had issued 1.403 trillion renminbi worth of debt (data from JP Morgan via Survived Sars). It remains to be seen where the limit of domestic Chinese savers appetite for these bonds will end. In the meantime, it does present an interesting wrinkle into the deflation/inflation debate in China. Which force will prove stronger? The restructuring of the Chinese economy, with the loss of all those jobs at SOE’s and other inefficient businesses, introduces deflationary pressures on the Chinese economy, while the increase in the money supply prompted by the inability to sterilize all those dollar purchases goes the other way, inducing inflation.

One final thought – the Chinese have really bucked the recent trend to “move to the corners” in determining what type of exchange rate regime to run. Much recent economic literature has suggested that running “intermediate exchange rate regimes” i.e. managed floats, basket pegs, crawling bands and the like, are too difficult to run in a world of increasingly mobile capital. Speculative pressures will sooner or later challenge the credibility of intermediate regimes and countries will thus be forced to move to the corners and adopt either full floats or hard pegs such as currency boards or dollarization. (See Eichengreen, or Fischer on the benefits of moving to the corners, or Frankel on why he thinks they overstate the case.)

Here are Stan Fischer’s comments on this issue –

Proponents of the bipolar view—myself included—have perhaps exaggerated their argument for dramatic effect. The correct formulation probably goes as follows. For countries open to international capital flows, (1) pegs are not sustainable unless they are very hard indeed, (2) a wide variety of flexible rate arrangements are possible, and (3) most countries' policies will still take some account of exchange rate movements.

Countries open to capital flows can adopt a wide range of arrangements, from free floating to a variety of crawling pegs with broad bands around them (under which the central exchange rate is frequently and marginally adjusted), as well as very hard pegs sustained by policy commitments such as currency boards, dollarization (or, more generally, the adoption of another foreign currency as legal tender), or membership in a currency union. But what does this exclude? In essence, fixed, adjustable-peg, and narrow-band systems, in which a government is committed to defending a particular value (or range of values) of the exchange rate, but is not committed to devoting monetary (and, on occasion, fiscal) policy solely to the goal of defending the parity.

Note the key issue here are capital flows. Going forward, it looks like the name of the game in China will be preventing too much hot money coming in to go long on the renminbi. Given that their hard currency reserves should approach the 1 trillion dollar level within the next year or so, I’m not sure I’d bet against the PBoC’s ability to throw its weight around in foreign exchange markets. Still, it’s too soon to tell how this will play out.

Economics