(Yicai Global) June 11 -- Recent large fluctuations in the yuan's exchange rate against the US dollar has sparked heated discussions about the direction of the Chinese currency.
Some of the burning questions are: Would a devalued yuan boost the Chinese economy? Does the currency have grounds for depreciation? What is the exchange rate's critical point? How will China advance exchange rate reform?
The central bank claims that improving flexibility and maintaining stability do not contradict one another, but have a common grounding, Dr. Sheng Songcheng told Yicai Global in an interview. He is adjunct professor of economics and finance at the China Europe International Business School and a former director general of the financial survey and statistics department at the People's Bank of China.
"The flexibility refers to the medium and long-term adjustment of the forex system aimed at effectively resisting external shocks, and securing independent monetary policy while making it more operational," Sheng said. "But it does not submit to -- or even encourage -- big swings in the short-term. A stable exchange rate will benefit the real economy and help stabilize the financial markets, because it can reduce the impact of speculation and therefore catalyze solid expectations."
"Maintaining a stable exchange rate is China's means to pave a way for long-term reform," he added.
Below are highlights of the interview.
Yicai Global: The exchange rate is regarded as a "buffer" that can be used to boost the economy or partially offset external impacts. But China has repeatedly stated that it will not use its currency to do so. What do you think about this?
Sheng Songcheng: Considering how external uncertainties have recently risen, using depreciation as a means to accelerate economic growth or to offset external impacts is unwise. China has insisted many times not to resort to "competitive depreciation." As early as April last year when the China-US trade dispute emerged, I suggested that we must learn from the lessons that Japan went through in order not to turn the trade tiff into a financial one.
Large-scale depreciation will generate many problems. First, it will increase the pressure of capital outflows, damage China's image as a major economy, and heat up trade frictions. Secondly, net exports contribute little to China's economic growth. Its contribution to China's gross domestic product turned negative (-8.6 percent) last year as the nation's trade surplus narrowed. Promoting exports through depreciation may give us price advantages in the short term, but is not beneficial for companies that want to improve their product quality and competitiveness. This depreciation would also hinder China's imports. China's imports made up 10.8 percent of the global market, making it the world's second-largest importer after the US. China's demand for imports of high-tech products and high-end services is very great during its economic transformation.
When the US tariff increase came into effect, I proposed that a stable exchange rate would help China's economic transformation. A large depreciation would do more harm than good. Balancing market confidence while keeping expectations for the exchange rate under control would effectively reduce panic at a lower cost. So, the benefits far outweigh the costs.
Long-Tern Yuan Appreciation
YG: The People's Bank of China has rarely interfered with the forex market. The yuan's future development will rely more on market demand. Are there grounds for yuan depreciation?
Sheng: The yuan will rise in value in the long term. China's economic growth potential outstrips its peers. China has become the world's second-largest economy with an economic output making up 15 percent of the global total, and yet it accounts for over 30 percent of global growth. However, China's per-capita GDP is less than USD10,000, which means that the potential for economic growth is considerable.
Raising import duties poses little impact on China's steady economic growth even in the short term. We should see the actual effects of the US tariff increase comprehensively and dynamically. The market always actively seeks ways to reduce trade costs, which will offset any extra costs of tariffs. China's export destinations are increasingly diversified, and our economic restructuring and reforms advance steadily. We have enough financial macroeconomic control tools and space to exercise them. We will further open up our market to the world. China is still a hot destination for global investment.
US tariff hikes also harm the interests of its companies and consumers. The prices of US intermediate and end products have surged while the diversity of imported goods has declined over last year, according to the US-based National Bureau of Economic Research. The cost of raised duties on foreign goods has been mostly passed on to US consumers. The higher levies cost US consumers and businesses an average of USD1.4 billion per month as of the end of last year, the report added.
US Dollar May Soften Further
YG: The dollar has been weakening these days. Does this help to stabilize the yuan-dollar exchange rate?
Sheng: The US economy is at the top of a cycle. The market estimates that the Federal Reserve is likely to cut interest rates within this year, weakening the dollar. Long positions on gold futures and options held by hedge funds on the Comex Gold Futures rose 38 percent last week (the week ended June 4), which is the largest increase since 2007, according to statistics from the US Commodity Futures Trading Commission. This is another sign that the dollar is weakening.
Changes in the exchange rate are always relative. Thus, the yuan-dollar rate will not depreciate but instead is likely to appreciate in the long run. Keeping the yuan stable does not mean taking a step back from forex reform, but involves avoiding damage that unnecessary big fluctuations would cause to the economy.
Stabilizing Expectations Is Vital
YG: Market participants have been discussing whether the yuan will hold at a certain point. PBOC Governor Yi Gang doesn't think it is most important to keep the yuan exchange rate at a certain figure, instead, he is very confident about stabilizing the rate at a reasonable and balanced level. How do you interpret his words?
Sheng:The motivation for reform of China's exchange rate market is to advance the balance of cross-border payments and enhance flexibility in the economy to tackle external shocks via spontaneous adjustments. For the current account, appreciation or depreciation of the exchange rate can promote balance in trade. But for the capital account, changing market sentiments can cause excessive short-term capital flows.
Sharp exchange rate fluctuations cannot stabilize capital flows -- they are likely to have an exactly opposite effect -- so stabilizing expectations of the exchange rate is vital. The objective fact is that there are no fundamental factors for the yuan-dollar central parity rate to exceed 7 so the rate will not exceed 7 -- and not because of China's actions -- but because of domestic and foreign economic and financial factors and present circumstances.
Stability and Flexibility Are Not Contradictory
YG: Most people stress that China needs to enhance the flexibility of fixing the yuan rate and expand bilateral volatility in order to curb unilateral bets on the market. Is this contradictory with keeping the exchange rate stable?
Sheng:These two concepts are not contradictory at all but integrated. Keeping the exchange rate basically stable is a long-term move to fight external shocks and keep monetary policy independent and more operational instead of giving in or even encouraging sharp exchange rate fluctuations in the short time. In fact, keeping the exchange rate steady will benefit the real economy and the financial market because it enables stable expectations, reducing the interference of speculative factors.
One important gauge to measure whether one specific rate is important is to see its impact on short-term volatility. A rate with bigger impact is more important than that with a smaller one. This is why the market is sensitive and pays attention to specific points. We must be aware of the different demands. For example, demand for a normal exchange rate in the real economy and demand for short-term speculation. On the one hand, giving full play to the market's function of price discovery, and on the other hand, preventing speculators from taking advantage of short-term exchange rate fluctuations.
YG: International practices consist of both completely free-floating exchange rates and stabilized exchange rate regimes. What should we do to advance the marketization of the yuan?
Sheng: More countries employ a stabilized exchange rate mechanism, according to statistics from the International Monetary Fund. Forty-two percent of the IMF's member states deployed a floating exchange rate regime in 2009 and the figure fell to 39.5 percent in 2017, remarkably dropping 1.5 percentage points. And 34.6 percent of IMF member states employed a highly flexible exchange rate system in 2009. This figure dropped to 42.2 percent in 2017. The proportion of member states with a stabilized exchange rate regime increased 5.6 percentage points from 2009 to 2017.
The managed floating exchange rate regime that China employs belongs to the category of stabilized exchange rate regimes. Why have more countries chosen stabilized exchange rate regimes over the past 10 years? How to balance the profit and cost of a completely free-floating exchange rate? These two questions are worth thinking about.
Stable Exchange Rates Help Long-Term Reform
YG: Does the stability of the yuan's exchange rate help to deepen exchange rate reform?
Sheng: Exchange rate policy is ultimately a national act and must serve the general strategy of the country's economic development. A nation's economic structure and development stage will affect the choice of its exchange rate regime and policy since its effects on different economic entities vary. For example, the non-trade sector often benefits from a strong local currency, while the foreign trade sector prefers depreciation of the local currency. Keeping the basic stability of Chinese yuan's exchange rate will buy more time and space for further deepening of the reform of the forex market.
Net exports accounted for a large share of China's economic growth and made a double-digit contribution to our GDP for a long time in the past. When the yuan faced great pressure to appreciate, the People's Bank of China boosted foreign reserves, raised reserve ratios and issued central bank bills to hedge against the natural increase in foreign exchange holdings rather than letting the yuan appreciate substantially. The PBOC managed to achieve basic stability, promoted China's foreign trade and made China the world's largest importer and exporter of goods.
China has been increasingly depending on domestic demand rather than trade surpluses in order to stimulate economic growth in recent years, and its tolerance for exchange rate fluctuation has improved a lot. However, it is still at the lower end of the global value chain, and exporters often have to bear the risk of forex rate volatility. Therefore, keeping a basically stable exchange rate remains highly important at this stage.
The stable rate can also help in internationalizing the yuan and implementing the Belt and Road Initiative. Maintaining a relatively steady exchange rate will help in establishing the yuan's reliability worldwide. For example, the US dollar was pegged to the gold standard at the beginning of its internationalization, which helped the US government gain reputation in terms of fighting inflation.
When Chinese products have enough advantages to transfer exchange rate risks actively rather than merely bear the cost of these fluctuations, and when the Chinese yuan is more widely accepted across the world, the yuan will float more freely and the conditions for marketization will become more mature. The development of China's financial market and the coordinated reforms of its economic and financial fields will facilitate exchange rate reform.
Keeping the yuan's exchange rate stable at a reasonable and balanced level does more good than harm regardless of the long-term basic factors or the current international economic and financial conditions. The PBOC has adhered to such guidelines during times of volatility in recent years. This effectively eased panic reactions in the market and stabilized the yuan's exchange rate with proper means and little cost. It also preserved China's foreign exchange reserves, created conditions for the smooth operation of the country's economy and finance, and contributed to the coordinated progress of various reforms in China's financial sector.