China Can't Quit the Dollar

There's only one exchange rate that really matters.

No one wonders what the yuan is worth against the dirham.

Photographer: Jie Zhao

China's leaders are hardly disguising their fears about money leaving the country. They've just imposed new disclosure rules limiting how Chinese -- who are allowed to convert up to $50,000 worth of yuan into foreign currency each year -- can spend that money overseas. Simultaneously, they're striving to tamp down worries about the tumbling yuan, which has fallen to an eight-year low against the U.S. dollar. At the end of December, the government added 11 currencies to the basket against which it now values the yuan. While the Chinese currency fell 6.5 percent against the dollar in 2016, its value measured against the broader basket has remained largely stable since July.

The idea, at least in part, is to persuade ordinary Chinese that their nest eggs are safe in renminbi. Unfortunately, this latest effort isn't likely to work any better than earlier ones. The yuan remains inextricably bound to the U.S. dollar -- and everyone knows it.

The People’s Bank of China created the exchange-rate basket roughly a year ago. The goal was twofold -- to shift attention away from the yuan's precipitous decline against the dollar and to reduce China's dependence on the U.S. currency. The latter was widely seen as humiliating -- an affront to a rising superpower and the world's second-largest economy. That resentment helped drive China's effort -- since stalled -- to internationalize its currency.

QuickTake The People's Currency

Yet any cursory review makes clear that the link between the yuan and the dollar remains as tight as ever. In November 2016, 98 percent of turnover in China's foreign-exchange market took place between those two currencies. Flows of capital into and out of China show an only slightly less lopsided pattern. Between them, the U.S. and Hong Kong dollars (the latter is hard-pegged to the U.S. currency) account for 91 percent of China's non-yuan international bank transactions. The smaller currencies that make up nearly half of the basket comprise only 1.7 percent of international bank payments and receipts.

Even the Bank for International Settlements estimates that 80 percent of China's local loans in foreign currency are denominated in dollars. That's the number that really matters: If the yuan continues to fall against the dollar, companies are going to have a harder time paying back those loans regardless of what the renminbi is or isn't worth against the government's official basket.

All this is clear to ordinary investors. During my nearly eight years in China, I've never heard any Chinese citizen worry about the value of the yuan against the Emirati dirham. So as long as the yuan continues to depreciate in dollar terms, Chinese are going to look for ways to get their money out of the country, despite any barriers the government might throw in their way.

China's options for preventing further outflows are limited. The PBOC could continue to deplete the country's $3 trillion in foreign exchange reserves in an effort to prop up the yuan. That's a risky game, though, as it reduces the stockpiles of hard currency needed to repay foreign-denominated debt and provide liquidity for international trade. As others have argued, reserves should be deployed strategically, not squandered defending bad policy.

The implicit dollar peg shrinks the government's other policy options. With the Federal Reserve set to raise rates at least once and possibly as many as three times this year, the PBOC faces pressure to raise rates too -- or to let the yuan fall even faster. Simply put, the link to the dollar limits the independence of China's monetary policy.

Tweaking the currency basket isn't going to help. One intermediate step China could take is to make it easier to trade and transact in currencies other than the dollar. The government has already eased rules on central banks and institutions trading Chinese fixed income and yuan in order to jumpstart what officials hope will become a broader market. The government could take similar steps to encourage growth in non-USD payments and trading -- paying for steel imports in Korean won, for example, or acquiring a Thai factory in baht.

Ultimately, of course, the only way to break free of the dollar is to accept a floating currency without capital controls. The government shows no appetite for the volatility this would entail, not least because in the short run, downward pressure on the yuan would prompt even larger outflows. But cosmetic changes to a basket of currencies -- most of which don't even trade with the renminbi -- are no substitute.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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