In recent years, China has relied increasingly on tightening capital controls to prevent excessive CNY depreciation, even as it appears more relaxed about permitting greater movement in the CNY against the US dollar.
In combination with a credible policy regime, the Chinese authorities’ ability to manage the financial account limits the PBoC’s reliance on reserves to manage the currency. The PBoC has probably grown more tolerant of exchange-rate volatility because the direct spillovers from CNY rate weakness into domestic credit conditions now appear to be much lower than was the case in 2015.
A weakening CNY would risk significant spillovers to other Asia-Pacific markets
The currency composition of China’s debt stock (largely in CNY), the sheer size of its economy and tradeable sector, and the much reduced sensitivity of domestic credit conditions to exchange rate movements mean that currency weakness tightens financial conditions in China far less than in most other emerging markets.
A weak CNY that does not tighten Chinese financial conditions would raise the competitive challenges for the rest of Asia. But a weak CNY that does tighten Chinese financial conditions would be a more substantial challenge as it would also likely be associated with weakening Chinese demand.
While outcomes such of these of course are possible, the risk would seem to be low. China’s focus on economic growth and providing employment are likely to, as is the case in most countries, be even stronger after the negative labour market impacts of COVID-19.
Currency depreciation that encourages destabilising capital outflows would be counterproductive to such objectives.
Weaker us fundamentals could boost the CNY in relative terms
In the meantime, US economic fundamentals have deteriorated significantly as a result of the Coronavirus crisis.
Total US federal debt as proportion of GDP stood at about 108 per cent in the first quarter of 2020, while real GDP contracted by nearly 11 per cent in the first half of this year.
Although a rebound is expected in the second half of 2020, it could be several years before the US economy surpasses its earlier level of activity.
At the same time, the Federal Reserve’s balance sheet has grown considerably, interest rates remain at the lower bound, and both the central bank’s asset holdings and the federal debt and deficit will continue to grow rapidly for the foreseeable future.
These factors may exert a lasting structural drag on the dollar, which would imply a stronger CNY. To some degree, CNY movements will remain a relative game.
The USD’s value erosion, however, shouldn’t distract from the CNY’s three-peat. For the third crisis in succession the CNY has defied expectations that it might propagate the crisis.
Instead, it has retained both the flexibility and ability to move, while also delivering only a modest currency adjustment. China’s currency has come of age.