ZHOU Hao: The Right Path and Proper Pace of RMB Foreign Exchange Reform


---Speech Delivered at Tsinghua PBCSF Financiers Forum

Ladies and Gentlemen,

Welcome to PBC School of Finance!

Governor Mervyn Kinghas just delivered a fantastic speech. It reminds me that in 1999, when the EURO Currency was launched, the late Nobel LaureateMilton Friedmanmade a prediction: the launching of the EURO willendanger the European Union, and the Currency Unionmay be dissolved in ten years. His prediction was a little premature, but in just nine years we almost witnessed Grexit in 2010 and we did witness Brexit in 2016.I doshare the same view with Governor King on the Euro issue.

I would like to move on to another topic, which is equally importantif not more important than Brexit or Trump’s election---RMB Exchange Rate Reform. I would like to present a thesis on theproper policy choices of RMB Reform going forward as of now. In order to establish such a thesis, I have tofirst discreditthree wrong choicesthatwe should nottake.

One popular butwrong choice isthe one-off large evaluation. The first reason why it is wrong is (that) it doesn’t pass thesmell test---many advocators of this choice are actually hedge fundshorting RMB currencyonoffshore markets. The second reason why it is wrong is that,from some leading economicmodelforecasts, it is not clear whether RMB is nowseverely overvalued or undervalued (e.g., the model from the Division of International Finance atthe Federal Reserve, where I worked from 2000 to 2013). The third reason why it is wrong is coming from historical lessons. We cannot predict when the exchange rate will reach its equilibrium state. During the 1997 Asian financial crisis, some countries in SoutheastAsia had hoped that an18% one-offdevaluationmay stop the capital outflow and currency crises;but in the end even 60% or moredevaluation had not stopped the crises.

The second popular but wrong reform choice is theimmediatefree float of RMB exchange rate. It is a strong voice supported by manyadvisors andinstitutions, including a prominent former member of the PBoCMonetaryPolicy Committee. Such a view has a strong impact on the public opinion,but I would argue (that) it is a wrongchoice.

China is a medium or low income country on per capita basis ($6,000 to $8,000),maybe even lower than mostAsian countriesduring the 1997Crisis (adjusted for inflation). Academic research including IMF studies have shown that, for a country of medium and lower income level, when the financial system is running sucha high debt level and there is potential systemic riskcascade in the financial sector(like Thailand and Malaysiain 1997), it is never an optimal policy choice to make capital account fullyconvertible or exchange ratefreefloat. We can debate on this issue, but the immediatefreefloat of RMB will not solve the currency depreciation and capital flight problems.

Some prominent policy advisorshave raised the hot debatesabout“whether to protectthe exchange rateor forex reserve”and “whether to protect thehousing price or exchange rate.” But these are wrong questions to be asked!The Central Bank or the Government (in the case of China, the State Council) is supposed to targeteconomic growthand price stability as the final policy goals. All other considerations, like exchange rate, reserve level, housing price are merely intermediate policy objects---that can be higher, lower, or unchanged---in order to improve the aggregateperformance of the macroeconomy.

The third wrong proposal is toroll back the partial capital account opening already in place. This is again a strong voice heard near the end of 2016 and 2015, when the capital flight situation is worsened. The main advocators include another prominent former member of the PBoCMonetary Policy Committee. Some advisors had even proposed to cut the $50,000 limit on individual forex account conversion to $10,000.Fortunately, such a terrible proposal was fiercely rejected by the State Council. 

Gradually opening the capital account and changing the exchange rate regime from fixed to floatin China is a one-waytrain ticket, in my view. Think of a countryissuingsovereign bond. If it defaults on its bond, the country is going to be shut out of theglobalcapital market for a long time, say, five to ten years. I would argue thatexchange rate regime change and capital account openingin China are not only external economic reform measures, but also a political promise that cannot be rolled back. As we are entering 2017, the messages from the Central Bank and the Government are veryclear that, the capital account openingpolicy will stay the course. We are not materially rolling back capital account opening policy, but are only attacking some of the illegal, underground, and murkyforex business, and are definitely not taking back the $50,000limits on individual forex accounts.

These are three wrong policy choices for currency regime reform. Going forward, the right choice of RMB reform is to more and more rely on flexible interest rate policy to guide the expectations of RMB exchange rate. Since the interest rate liberalization---the most important internal financial market reform---had been largely accomplished around the end of 2015, such a flexible interest rate policy can guidethe RMB exchange rate expectation as a viable policy choice now.

The policy of interest rate adjustment would first meet the domestic economic policy goals, and asa byproduct, it can also guide the market expectation on RMB exchange rate. Inassessment of what the exchange rate of RMB to USD might be going forward, one need to consider both the global and the domestic economic situations.

The most important regime shift in economicpolicyglobally,is the shift from excessively relying on ultra-loose monetary policy toimplementing more active fiscal stimulus policy. We have seen indications after Brexit: to counter thepotential futurenegative effect andhuge uncertainty from the “devoice”, Theresa May’s governmenthas at several occasions indicatedfuture fiscal policy relaxation or stimulus---aclear reversal to the previous Cameron’s government fixation on deficit reduction. It would be a right policy choice going forward to smooth the transition pain of Brexit. We have also seen from Trump’s election in US:Trump’s team has also promised one trillion or morefiscal stimulus, half of which will be in the form of tax cut, and halfin the form of infrastructure spending. We have already seen that the ten year interest rates in US and globally have jumped up atleast 100 basespointssince theSeptember election. We also have seen evidence that,Euro area and Japan’s negative interest experiments have failed---it destroys financial intermediaries’ profits and money marketfunds,withouteffectively transmitting the stimulusbenefitsfrom central bank’s negative interest rate to the final demand---household expenditure and corporate investment.There is a clear global trendof switching from excessive moneyliquidity to active fiscal stimulus.

Under such a global economic policy environment,China will be facing rising interest ratesnot only globally, but also internally. It is likely that the interest rate policy would be tight and possibly rising.

Unlike other leading central banks, PBoC has five policy goals.Imaging that you were sitting in the quarterly meeting of the PBoC’s Monetary Policy Committee, you would be deliberating on whether to increase or decrease the policy interest rate, considering all the five policy objectives.

The first and most important goal is economic growth.If you believe Statistics Bureau of China’s release, you must see that PMI is rising, GDP is firming, employment is healthy, and wage is increasing. With growth targets stable and improving, the proper interest rate policy would be at least stable and likely increasing.

The second goal isstable inflation (around 3% to 5%). We have already seen thatPPIhas accelerated from -6% to +5%during the past year, and CPI has firmlyrebounded toabout 2%to 3%.So the inflationgoal also indicates a tight and perhaps rising policy rate.

The third goalis financial stability. We have already experienced a stock market bubble in 2015, a housing bubble in 2016, and some asset bubbles in other areas now (insurance). As we know, asset bubbles arise due to too much liquidity and/or too low interest rates. Reducing the likelihoods of asset bubblesand the consequence of bubble burstingcan prevent severe recessions of the real economy.PBoC is likely to adopta policy oftight, stable, and perhaps rising interest rate.

The fourth goal ofthe Chinese central bank, uncommon to other leading central banks, is the external balance---trade balance and exchange rate stability. Given that the US Fed policy rateis likely toincrease 2 to 3 times during 2017, and with improving economic situationsin China (items one to three),PBoC’s short-term policy rates---overnight repo rate and SHIBOR rate---arelikely to rise gradually,due to the domestic economic strengths, whichalso brings a byproduct---stable expectation of exchange rate of RMB to USD. This is clearly evidencedby the first two weeks of 2017; we have already seen that RMB to USD exchange rate has been appreciating from 6.95to 6.89. I would like to remind you that thisis nota coincidence, but, according to my analysis, isconfirming what is happening in China and in US, both in terms of real economiesand interms of long term interest rate, as well as in terms of the monetary policy stancesin both countries.

The last policy goal of PBoCis structural balance, unlike other major central banks, including industrial structural reform. There is an old saying that when the tide is high, you cannot tell who is swimming naked. To help the fiscal side and the government to better perform the structural reform, the proper monetary policy should neverbeultra-loose, but should be firm and neutral;such that good companies canget loans, and bad company cannot.

Just to summarize,during such an imaginary quarterly meetingof the PBoCMonetary Policy Committee, all thefivepolicy objectivesof PBoC and the current economic situationssuggesta likely tighter or gradually rising interest rate.

Based on the above discussionson the wrongreform choices (for RMB exchange rate), the right reform choice, global and domestic economic situations, we can project what is likely to be RMB policy regimeand the expectation of RMB exchange rate going forward.

While muddling through seems to be a wrong policy for the Euro currency area, as Lord Mervyn King has argued passionately, it actually seems to be the right policyin China for RMB reform.RMBexchange rate policy going forward should not be reverting tototalcapital control or fixed exchange rate, norimmediate free float or one-offlarge devaluation. In the near future, wewill stick to the basket rule---a combination ofyesterday’s market closing RMB currency priceand a basket implied stable RMB exchange rate---the dual track system: a market track plus a control track. So PBoCwill choose the weights between the two tracks aseconomic situation demands.If the reform goessmoothly in the future, the weight will be more on market closing price. If the situation is somewhat unstable or uncertain due todomestic financial instability ormacroprudential worries, then PBoCwill put more weight on the basket stability.

In conclusion, RMB exchange rate reform will stay the course of gradual reform towards full convertibility and free flow, and will not go back to the old regime of capital control and fixed rate, nor will have an overnight sudden change of large devaluation or total float. Given the US and China’s economic situations, given the policy stances of both central banks, my person qualitative assessment is that RMB exchange rate to US dollars would likely to have a net depreciation in 2017,just like last two years, but therelative magnitude of devaluation will be much smaller than 2015 and 2016. The probability of RMB exchange rate to US dollars appreciation is actually higher in 2017 than the last two years.

Thank you very much!

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>Tsinghua National Institute of Financial Research