Several market experts have already explained the dilemma that the central banks of various countries are currently facing. Continuing with the measures that have already failed doesn’t seem likely to lead to the desired results and at the same time, not doing anything will pose some risks as well.
When it comes to China’s situation, the dilemma goes like this: if its policy makers decide to hike interest rates to support the yuan and control the surge of capital leaving the Asian country, then the Chinese exports will lose to its rivals with weaker currencies.
This is the disadvantage of keeping a peg to the US dollar. The peg gives stability and almost assures competitive exports to the United States. However, this peg ties the Chinese yuan to the stronger greenback, making the official currency of China stronger.
On the other hand, if the policy makers of the Asian nation decide to move the interest rates lower and cheap credit floods the economy, the capital moving out of China rises, as investors flee the country to escape the loss of purchasing power that the devaluation of the yuan will bring.
In short, depreciating the yuan to ramp up exports encourages capital outflow from China, forcing its central bank to use up reserves to mediate the flood of capital flowing out of the country. Alternatively, supporting the currency negatively affects exports and might eventually lead to mass layoffs in some sectors with thin margins and complex black box financing.
Knowing this, it appears to me that whichever China opts to do, it will lose in one way or another. Not doing anything won’t be a suitable course of action either, as the incompetence of the officials of the central bank is now evident.
Certainly, policy makers will have a hard time to decide which path to tread, but I believe that they should evaluate and take action as soon as possible. Prolonging won’t do any good and for me the best option would be the one which will present less risks when implemented.