China's Central Bank Is Facing a Major New Headache

  • Economist: It may take a while before the situation stabilizes
  • Central bank focus for yuan seen shifting as FX reserves bleed

PBOC to Face New Pressure in January

People’s Bank of China Governor Zhou Xiaochuan already has one policy headache with the currency falling to near an eight-year low. He could have an even bigger one next month.

That’s when a $50,000 cap on how much foreign currency individuals are allowed to convert each year resets, potentially aggravating capital outflow pressures that are already on the rise. If just 1 percent of China’s almost 1.4 billion people max out those limits, that’s an outflow of about $700 billion -- more than the estimated $620 billion that Bloomberg Intelligence estimates indicate has already flowed out in the first 10 months of this year.

Middle class and wealthy Chinese have been converting money into other currencies to protect themselves from devaluation, exacerbating downward pressure on the yuan. Outflows could intensify if Federal Reserve interest-rate hikes fuel further dollar appreciation.

That leaves Zhou in a bind identified by Nobel-prize winning economist Robert Mundell as the “impossible trinity” -- a principle that dictates nations can’t sustain a fixed exchange rate, independent monetary policy, and open capital borders all at the same time.

"At a moment like this, you have to compare two evils and pick the less-worse one," said George Wu, who worked as a PBOC monetary policy official for 12 years. "Capital free flow may have to be abandoned in order to maintain a relatively stable currency rate."

China is moving further away from balance among trinity variables, at least temporarily, and "it may take a while before the situation stabilizes" for the yuan and capital outflows, said Wu, who’s now chief economist at Huarong Securities Co. in Beijing.

The global landscape complicates policy. Japan and Europe remain fragile, with negative policy rates. And in addition to a likely Fed hike in two weeks, U.S. President-elect Donald Trump, who has criticized China’s trade and currency policy, takes office Jan 20.

"How the Chinese government responds to this and how the new U.S. administration responds to the Chinese government’s responding to this is the kind of stuff to watch," Paul Gruenwald, chief Asia-Pacific economist at S&P Global. "China’s authorities have to figure out what the best combination is."

Gruenwald identified three options to counter the outflows: capital controls, burn their international reserves or let the currency weaken.

A mix of all three has already been occurring as policy makers opt to preserve monetary policy independence above all else. With economic growth stabilizing -- a report Thursday showed the official factory gauge matched a post-2012 high -- the PBOC has kept its main policy benchmarks on hold for more than a year and has been using new open market liquidity tools to effectively tighten monetary conditions.

Read more: PBOC’s shift toward selective tightening

So rather than raise borrowing costs to try to make domestic returns more attractive -- China has added new restrictions on the flow of money across its borders. They include a pause on some foreign acquisitions and bigger administrative hurdles to taking yuan overseas, people familiar with the steps have told Bloomberg News.

The offshore yuan headed for its biggest weekly advance in more than 10 months late Friday after money-market rates climbed, policy makers tightened curbs on capital outflows and the dollar’s three-week rally faltered.

China should cut intervention in foreign exchange markets while stepping up capital control, Yu Yongding, a former academic member of the PBOC’s monetary policy committee, said Friday at a conference in Beijing. Yuan internationalization shouldn’t be promoted too aggressively, said Yu, a senior research fellow at the Chinese Academy of Social Sciences.

PBOC Deputy Governor Yi Gang said Sunday that foreign reserves are "very ample" and the yuan will remain stable, while Guan Tao, a former official with the State Administration of Foreign Exchange, wrote in a commentary on Thursday that yuan bears were being stubborn.

SAFE, which executes currency policy, and PBOC didn’t reply to faxed requests for comment.

Read more: PBOC seen shifting focus in yuan fight as reserves drop

About $1.5 trillion has exited the country since the beginning of 2015, Bloomberg Intelligence estimates show. While China still has the world’s largest foreign exchange stockpile, the hoard shrank in October to a five-year low of $3.12 trillion, PBOC data show. That means there’s less in the armory to battle depreciation if China’s famously frugal savers park more cash abroad.

Read more: a QuickTake explainer on China’s managed markets

The outflow pressure rose in January as individuals socked away a record amount in domestic bank accounts denominated in other currencies. Household foreign deposits surged 8.1 percent to $97.4 billion, according to the central bank, for the biggest jump since it began tracking the data in 2011. Those holdings stood at $113.1 billion in October.

The start of next year is likely to bring an even bigger jump in such transactions because many Chinese expect the dollar to strengthen, according to Ding Shuang, head of China economic research at Standard Chartered Plc in Hong Kong.

That means policy makers are likely to draw more on reserves to protect the yuan because they prioritize keeping it stable, Ding said. Capital controls also are likely, especially those to curtail outbound foreign direct investment that’s being used solely as a vehicle to move capital out, he said. Ministry of Commerce data show January to October ODI jumped 53.3 percent from a year earlier.

If the country stays committed to capital account liberalization, it should strengthen the use of interest-rate instruments to influence the yuan exchange rate indirectly so as not to frighten away global investors, according to Raymond Yeung, chief greater China economist at Australia & New Zealand Banking Group Ltd. in Hong Kong.

"Further delay in interest-rate reform will make Chinese assets less attractive," Yeung wrote in a recent note. "The free flow of capital is critical to China’s financial sector development, which will benefit from higher involvement of foreign institutional investors."

For now, the entry door is still opening, with new trading links and increased access to its capital markets. It’s the exit door that is going the other way as the impossible trinity bites.

— With assistance by Heng Xie, and Yinan Zhao

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