In the last few weeks, the financial markets were concerned about the dropping China’s industrial production that provoked the slowdown of the global economic growth. Moreover, in September, the exports from China contracted by 3.7% year-on-year, with imports contracting by 20.4%. The Chinese currency reserves showed the record slump in the 3rd quarter caused by the largest yuan devaluation effected since this August. On the IMF forum in Lima, Peru, the policymakers from People’s Bank of China said they would like to make yuan more market-oriented. Is the shift towards the more free-floating yuan possible under the current market conditions?
Global markets were rocked as China devalued yuan on August 11 by 1.9% against the US dollar, the biggest one-day move since the yuan was officially de-pegged from the US dollar in 2005. In three days, the value of yuan fell over 3% against the US dollar after the central bank announced it was moving to a more market based foreign exchange regime. Since then, China’s currency has appreciated 0.63%, but there is a widespread speculation that China may resort to more devaluation to help its exporters as its economy is slowing down. Recent trade balance report points to the success of devaluation policy: external balance has improved as Chinese exports declined by 3.7 % year-on-year in September while imports fell 20.4%. However, while currency devaluation improves trade balance it negatively affects capital inflows by making investments in the local assets less attractive. Capital flight thus prompted can result in increasing devaluation pressure, which may result in currency crisis. And even if a country has sufficient foreign reserves to prevent a currency crisis as China clearly has, capital outflows are undesirable as they weaken economy. So benefits of devaluation have to be weighed against the costs to economy in terms of lost foreign investments and increased financial instability induced by capital flight.
China was supporting yuan (while managing it within a range against the dollar) before August devaluation and the stock market rout. Its first quarter official reserve holdings declined by $113 billion to $3.73bn. The central bank intervened in the currency market to prop the value of yuan by selling dollars and purchasing its currency. The aim of the intervention was to support yuan and prevent capital outflows that the slowing economic growth and weakening yuan were causing. As many analysts have noted, the aim of the devaluation move in August was to keep yuan’s appreciation against trading partners’ currencies gradual: yuan rose together with rapidly appreciating US dollar while these currencies depreciated against the dollar. After August, surprise devaluation China continued currency interventions to support yuan and stem capital outflows. According to central bank data, China's reserves fell another $180 billion in the third quarter, with a $43.3 billion decline recorded in September. With total reserves of $3.514 trillion and current account surpluses, China can continue supporting yuan for quite some time. I do not believe the regulator will abandon the support and let the yuan free float under current circumstances, particularly as the Federal Reserve rate hike is being delayed. It will be counterproductive in terms of its efforts to stop the capital outflows. China needs to calm investors and restore confidence in yuan and its economy. The central bank has been loosening its monetary policy to stimulate the economy by lowering the required reserve ratio and providing financing for infrastructure investment projects through channels like supplementary lending to China Development Bank. I believe the sustained central bank support for yuan will continue, with yuan exchange rate against the dollar reverting to roughly its value before the devaluation - 6.11 yuan per US dollar.