Time for China to let go of the dollar

 

China’s Third Plenum reforms, introduced under the leadership of President Xi Jinping and Premier Li Keqiang in November 2013, promised deep market-based reform in the economy, including reform of financial markets and liberalisation of the capital account of international payments.

Among other things, the blueprint declared that financial markets would be freed up, continuing reforms that were already launched prior to the Third Plenum. Interest rate and capital account liberalisation would be accelerated, a system of deposit insurance would be set up, and private banks would be allowed for the first time. The changes in the financial markets were targeted at improving the ability of private firms to compete with state-owned enterprises. And importantly, China’s mechanism for setting the exchange rate was also set to be improved on the way to capital account liberalisation.

The re-appointment of Zhou Xiaochuan as governor of the People’s Bank of China (PBoC) in March 2013 was an important institutional statement of earnestness in the lead-up to the reforms, for two reasons.

It underlined policy continuity and the commitment of the new leadership to deepening market-based reforms. Zhou has been a driving force behind China’s financial liberalisation and his re-appointment signalled Beijing’s aim to put economic growth on a more sustainable footing through broad-based economic reforms. Zhou took the helm of the central bank in 2002 and led the drive to liberalise interest rates and abolish the renminbi peg to the US dollar, a step along the path to turning the renminbi into a global currency.

His re-appointment also strengthened PBoC’s institutional role in the policymaking hierarchy. To keep his post at the bank, Zhou was elevated to the Chinese People’s Political Consultative Conference (CPPCC) that carried ‘national-level leader’ rank and exempted him from compulsory retirement at 65 for officials in cabinet minister-ranked jobs. PBoC — long reliant on its policy knowledge and expertise for its clout, rather than its formal position in the system — thereby acquired new policy influence and heft.

Last week, at the China Development Forum in Beijing in the presence of IMF managing director Christine Lagarde, Zhou pledged further liberalisation of capital account controls this year in a bid to create conditions for the Fund to include the renminbi as an international reserve currency. Lagarde flagged easing the criteria for measuring capital account openness, a step that could boost the chances of the renminbi to join the IMF’s Special Drawing Right (SDR) in October at the Fund’s first review of the currency basket since 2010 — even if China has not by then fully opened up its capital account. She warned, however, that ‘a lot of work (still had) to be done’. A currency’s full convertibility is a normal criterion for its inclusion as an international reserve currency, like the US dollar, the euro, the yen and the pound sterling.

Zhou said that China would facilitate investment in domestic and international capital markets, opening its capital market to global investors, and allowing domestic investors to invest in and sell securities overseas. Currently foreigners cannot buy China-listed securities directly.

In this week’s lead essay Guonan Ma argues that: ‘It’s high time that the People’s Bank of China let the dollar peg go’. This would be an important step along the way to achieving Zhou’s ambitions for the yuan’s role as a global currency.

Ma points out that, while the 20-year old peg of the Chinese renminbi to the US dollar has served the Chinese economy well, its time is up. ‘As the biggest trading nation and second largest economy, China is too big to be anchored to any single currency, even in a loose fashion. A dollar peg has often amplified external shocks to the Chinese economy because of the dollar’s safe haven role. Although the US no longer welcomes the Chinese peg to its currency, it continues to demand nothing but “one-direction flexibility”‘. The US expectation, in other words, is that the renminbi should continue one-way appreciation against the dollar. In the long term, with China likely to gain in the productivity stakes vis-à-vis the United States and other economies, this makes good sense. But along the way there will be periods — such as the one both economies face now — when letting the renminbi slip against a strengthening ‘greenback’ (while continuing its rise against most other currencies) will make more sense in terms of sustaining Chinese demand and global growth.

Ma’s argument that the PBoC now needs to let the renminbi move more freely against the dollar while being prepared to lean against the wind by selling dollars out of its official reserves from time to time makes sense for a number of reasons.

The immediate impact would be to facilitate Chinese monetary easing and stabilise the effective exchange rate. In the longer term, it would help enhance two-way currency flexibility ahead of fuller interest rate deregulation on the way to greater capital account liberalisation.

There is no doubt that the renminbi will become a major international currency in future, as Lagarde proclaimed last week. Zhou’s declaration of an active agenda of capital account reform represents an important acceleration of momentum towards that goal. The journey could still be a long one. But China is now more clearly committed to making it.

Peter Drysdale is Editor of the East Asia Forum.