Progress in China’s reforms is often a case of “two steps forward and one step back.” If 2015 was a year of the two steps forward, is 2016 going to be a year of the retreat? Or will Beijing manage to avert an economic crisis and move closer to its long-term reform goals?

Policymakers are faced with a major conundrum, as the renminbi’s (RMB) volatility has increased, capital outflows have intensified and depletion of foreign reserves has accelerated (down some US$663 billion from their peak in June 2014) as a result of market intervention to stem the RMB’s precipitous decline (Displays 1 and 2).

Policy Trilemma

The problems seem vast and complex. But, in our view, they boil down to whether the administration wants to resolve, once and for all, the “impossible trinity” problem.

In international economics, it is well known that a country cannot simultaneously control interest rates and its currency while allowing free capital flows. Policymakers can only control two of those three elements and must forgo one. If capital flows are not to be restricted, the options for the authorities are either to pursue a stable exchange rate and forgo an independent interest-rate policy (as local rates will need to move in tandem with world interest rates), or to set their own interest rates but give up direct control of its currency (because the exchange rate will be determined by fund flows, which will be driven by interest-rate differentials). Alternatively, they can control both interest rates and the exchange rate, but in that case they will need to close the country’s capital account. The bottom line is, something has to give.

In China, the currency and the capital account have been mostly quite rigid, giving domestic monetary policy flexibility. But the ongoing liberalization in the currency and the capital account leaves only inconvenient options for Beijing in the face of persistent capital outflows—allow the RMB to depreciate freely; raise interest rates high enough to defend the currency (at the cost of sabotaging growth); or just shut down the capital account again.

If China wants to pursue free capital flows but not let go of its control over interest rates and the exchange rate, the only way would be to keep spending its foreign reserves to fight the tide on the foreign exchange market. But this obviously runs the risk of a quick depletion of the reserves, which in turn would add pressure on the currency again. China has never been in favor of a “big bang” reform. And with almost US$4 trillion of foreign reserves, we previously thought that the country would be able to implement liberalization at a measured pace, step by step. This, however, has not proved to be the case. The volatility in current global markets shows that the “China impact” was underappreciated, and the vast amounts of foreign reserve dollars wasted in fighting capital outflows are now being questioned.

Essentially, China currently has a choice of either letting the currency truly float, fulfilling market expectations, or resorting to capital controls (euphemistically termed “macroprudential measures”) to stop the bleeding for a while. Either way, there are consequences to bear.

Command and Control

If Beijing chooses the path of currency depreciation, it will be hard to tell where the bottom might be for the RMB. The currency may be liable to overshoot on the downside if fears in the market intensify.

Another aspect to consider is whether a cheaper currency can really boost export competitiveness when global demand is so sluggish. Sizable currency depreciations in South Korea, Taiwan and Singapore over the past year have done little to boost their export performances. Ironically, these countries all suffered bigger export contractions than China despite their weaker currencies.

Also, a big currency depreciation will heighten many Chinese corporations’ external repayment risk, since they have taken on considerable amounts of offshore liabilities over the past several years, when the renminbi was more stable and predictable.

So how about the macroprudential option? It is debatable whether that will actually work well either, but it is becoming more popular among policymakers across the globe.

But there are clear risks, such as the damage to the credibility of China’s push toward a higher level of free-market economy. But if the macroprudential measures do work, China can let things calm down for now and restart the reform push when market conditions improve.

The outlook for the RMB is also very much a call on the US dollar’s (USD) broader strength. If the greenback peaks out against major currencies in 2016, a lot of the pressure on the RMB would fade away. In this case, too, China can restart reforms later. Policymakers could be criticized for merely pushing the problem out to a future date, but, in the big picture it may be a risk worth taking from Beijing’s point of view.

Stable Currency Basket

Recent policy communications from the People’s Bank of China (PBC) have repeatedly emphasized the referencing of its currency to a basket of currencies. Indeed, despite the volatility of the RMB’s exchange rate against the USD, its levels against the currency basket have been quite stable over the past several weeks. We think this stability against the currency basket will remain the policy objective in the near term (Display 3).

All told, what’s our view? In short, we’re not in the camp forecasting a big devaluation. Nor do we expect the PBC to start a depreciation of the RMB against a broad currency basket—if it did, the RMB would fail to gain much credibility as a reserves currency.

In our view, there is already evidence that the PBC is leaning toward scaling back its capital account liberalization in recent weeks. For example, it announced a ban on foreign banks from conducting cross-border foreign exchange transactions and arbitrage activities for three months.

Moreover, controls on the amount of money that local residents can take out of the country have been further tightened to RMB50,000, and the PBC is said to be considering new tools to narrow the gap between the CNH (offshore) and CNY (onshore) markets by more blatant and direct intervention measures in the market.

CNY/USD Forecast In terms of our forecast for the RMB, our base-case projection is that the PBC keeps the RMB stable against the currency basket, while the USD’s uptrend peters out in 2016. In this scenario, we think CNY/USD will be at around 6.60 on a six-month horizon (against 6.58 currently). Its relative value against CNH/USD will remain volatile, but we expect the PBC to step up its effort to reduce the gap between the two markets, limiting the deviations.

Ideally, an export recovery will act as a powerful circuit breaker for the renminbi’s downward spiral. But, unfortunately, we have reservations about that scenario. China’s economic growth may show more stability if housing investment makes a comeback in 2016. This would help improve expectations on the RMB in general, but it still may not be enough to change the sentiment on the country’s foreign exchange policy. And, in the end, it’s important to remember that the direction of the USD seems to be the most crucial factor.

By Anthony Chan, Asian Sovereign Strategist, Global Economic Research, AB

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