INTERNATIONAL FINANCE

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George Magnus FEBRUARY 22 2016

The financial turbulence that gripped China and the rest of the world in the past few weeks has blown over for now. Last weekend, with the renminbi stable again, Zhou Xiaochuan, China’s central bank governor, broke a lengthy silence to insist that there was no basis for devaluation, that the country’s reserves were adequate, and that China had no need for tighter capital controls.

These assurances have worked for the time being but the causes of China’s large capital outflows could manifest themselves at any time. China has come up against a problem known as the “impossible trinity”. Resolving it, either by means of a devaluation of the renminbi or tighter capital controls, will have far-reaching consequences.

The impossible trinity, framed originally by the economist Robert Mundell in the late 1960s, is about the pursuit of incompatible objectives. Simply, it is impossible to simultaneously pursue more than two of an independent monetary policy, a fixed exchange rate and free capital movements.

China has a fixed but adjustable exchange rate, wants monetary autonomy, and has pledged to liberalise capital transactions. Something has to give, especially in view of the government’s passive attention to rapid credit creation, which surged again in January.

Opinion China

China’s ‘trilemma’ makes it vulnerable to more shocks

The point at which Beijing has to choose its trade-off is approaching fast, writes George Magnus

The point at which China has to choose its renminbi and capital regime trade-off is approaching fast. If China persists with capital liberalisation, it would have to allow the currency to fall sharply or float freely.

A small devaluation would barely offset Chinese wage gains, while encouraging expectations of further depreciation. A shock devaluation of, say, 40 per cent or more, would be politically dangerous and run against the grain of economic rebalancing.

If China opted to keep the currency relatively stable instead, it will probably have to introduce tighter controls over foreign currency transactions, about 80 per cent of which are fully or partly convertible, according to the International Monetary Fund.

In spite of Mr Zhou’s comments to the contrary, tighter controls would be more acceptable politically, though they would reverse the liberalisation programme. In recent weeks, China’s penchant for control has been evident. Checks and controls over foreign exchange transactions have been tightened. Banks have been subject to new currency trading restrictions; greater scrutiny, extending to punishment, is being exercised over outward capital transactions.

The immediate issue is the relentless decline in China’s foreign currency reserves, which have fallen from a peak of $3.9tn in 2014 to stand at $3.2tn. In January, they fell by almost $100bn. China’s reserves are still about twice as high as IMF prudential benchmarks suggest, but not if liberalisation proceeds without a more flexible renminbi.

In that case, and if capital flight continued, the reserves might not suffice to prevent a currency crisis for more than six to 12 months. The reserves, which equated to about 30 per cent of the money stock in 2008, are now only half that amount. The flow of new money and credit being generated would make the reserves vulnerable to random, large capital outflows.

Capital, other than for direct investment abroad, and trade finance, is leaving China for various reasons and in various, sometimes ingenious ways. The principal reasons are the “usual suspects” such as excessive credit creation, poor investment returns and profits at home, the implications of rising debt and deflation, and looser monetary policy expectations.

Confidence in the currency may have been undermined by perceptions of a delinking from the US dollar, suggested by the mini-devaluation last year and the adoption of a reference basket of 13 currencies.

Confidence in the currency may have been undermined by perceptions of a delinking from the US dollar

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Western economic thinking recognises China’s “trilemma” but insists that openness, freer markets and liberalisation are the way forward. Several hedge funds are said to have taken positions based on a devaluation.

These ideas, however — centred on the removal of direct interference in markets and a major change in regulatory and ownership policies — are easier to propagate in Washington or London than to accept in Beijing. This is especially so in China when appetite for reform is wilting.

Western ideas are seen as code for a shift away from the primacy of the Communist party towards global and private markets. The party’s raison d’être is to be in power and exercise control.

If global markets and reforms are seen as a threat, China’s instinct is to impose controls and shelve or roll back reforms. What happens to the renminbi is for another day.

The writer is an associate at Oxford university’s China Centre and senior economic adviser to UBS

Western ideas are seen as code for a shift away from the primacy of the Communist party