China's Big Dilemma — Currency Reform


China's central bank has been talking tough on currency reform while it has also intensified market intervention, highlighting the fine line it must walk in trying to liberalize the yuan.

Critics, including the United States, see the intervention as another sign that Beijing is dragging its feet in letting market forces determine the yuan's exchange rate.

But the wall of money being printed by China's trading partners under their super-loose monetary policies is flooding emerging markets with speculative cash, which has put the yuan under strong upward pressure this year.

"It's difficult to make the currency manipulation argument," said Zhang Zhiwei, chief China economist for Nomura Securities in Hong Kong. "There are a lot of things that central bankers are doing nowadays that are not really regarded as best practice; we are in uncharted waters these days and everything is relative."

The yuan is a closely managed currency that is allowed to trade 1 percent either side of a midpoint set by the central bank each day. However, Beijing is steadily relaxing its tight grip on the currency as it tries to restructure the world's second-biggest economy away from a reliance on exports and towards greater domestic consumption.

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Critics, including many Western governments, argue that Beijing is not opening its markets quickly enough and some suggest moves to date have lacked any real substance. For its part, China fears that opening up too fast will destabilize the economy.

Many dealers thought the central bank was signalling a loosening of its control of the market in the fourth quarter of 2012 when it largely abstained from its traditional role of buying up foreign exchange.

Even when companies refused to exchange dollars for yuan within the daily permitted trading band, prompting a collapse in trading volumes, the regulator stayed on the sidelines.

But 2013 has seen the return of a nanny central bank as the amount of dollars entering the economy picked up. China's foreign currency reserves, already the world's largest by far, swelled by $128 billion in the first quarter, the biggest quarterly increase since the second quarter of 2011.

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"Recent resumption of intervention on a large scale is troubling," the U.S. Treasury said in a semi-annual currency report issued on April 12.

The report argued that China was once again keeping the yuan at an artificially low level by buying up foreign currency. It also criticised China's unwillingness to disclose its intervention in a transparent manner.

As the People's Bank of China (PBOC) was intervening, central bankers suggested China remained firmly on the path of reform.

Deputy governor Yi Gang told an International Monetary Fund forum in Washington on April 17 that the time had come to widen the yuan's trading band again. A day later, he said conditions were ripe to further open up China's capital account.

(Read More: US Concern on China Currency Fades as Yuan Grinds Higher)

Yi's statements followed similar comments by a more junior PBOC official that were given prominent play in the official English-language China Daily.

The comments received less coverage in Chinese-language state media, which some dealers said suggested that the reform talk was political gesturing for foreign consumption.

Genuinely Bullish

Adding to the interventionist criticism, the PBOC set its daily midpoint at a series of record highs in the run-up to the G-20 meeting in Washington late last week, prompting speculation it was pushing the currency higher to head off potential criticism that it was undervalued.

"The slew of record-high midpoints are contrary to the PBOC's repeated pledge to keep the yuan stable," said a trader at a European bank in Shanghai. "Given this lack of transparency, lots of speculative talk is circulating."

The central bank let the yuan appreciate 2.36 basis points between April 12 to 17, setting record highs along the way, compared with a rise of only 1.54 basis points for all of 2012.

Those dates spanned the publication of the Treasury currency report, a visit to China by U.S. Secretary of State John Kerry and the G-20 meeting - events that have served as platforms for criticism of China currency controls in the past.

On the other hand, the yuan has continued to set record highs since the end of the summit, and PBOC data shows that corporates, both onshore and off, remain genuinely bullish on the currency.

What Foreigners Want

Another quandary for Beijing is that liberalization of the yuan, while economically beneficial in the long run, could impede in the near term the promotion of the usage of the currency in international trade.

Getting trading partners to invoice transactions in yuan would reduce exchange rate risk for Chinese firms and reduce the need to continue accumulating foreign currency reserves, which were equivalent to about 40 percent of China's GDP in 2012.

But profit-seeking companies are less interested in helping China reduce exchange rate risk than helping their own bottom lines, and when the yuan fell against the dollar in the first half of 2012 as the Greek credit crisis roiled global markets, companies backed off from holding yuan assets or settling trade in yuan.

"It's good to maintain at least a stable currency with some small appreciation," said Patrick Wu, head of yuan trading at JPMorgan.

"Today the renminbi obviously is outperforming. The reason is they want to show a good gesture to corporates saying, 'Come here, use our currency for settlement'."

This is not the same as liberalization, he said, but for the time being it is necessary.