China’s Gamble: How a Crusade to Prop Up the Yuan Imperils Other Pressing Mandates

Beijing’s aggressive approach threatens to shortchange the tasks of safeguarding economic growth

 .. the bank’s emphasis on propping up the yuan has constrained its ability to fight other economic ills such as persistent housing bubbles. “The issue of the exchange rate,” he says, “has become shackles on policy makers’ ability to take other necessary actions.”

.. China’s currency-first policy is risky because the country now faces what economists call the “trilemma,” the theory that a country can’t at once have a controlled exchange rate, free capital flow and independent monetary policy.

.. it is also creating unintended stresses, including heightened risks of a full-blown cash squeeze

.. Since then, the PBOC has spent $1 trillion, a quarter of its currency reserves, to control the yuan’s fall.

.. China isn’t seeking to stop the yuan’s fall altogether, but to guide it lower in an orderly fashion. Too sharp a drop could drive up inflation by increasing import costs and cause uncontrollable capital flight—battering confidence in the Communist Party.

.. A weaker yuan also makes it harder for Chinese companies, from state banks to airlines, to service their more-than-$1 trillion foreign debt.

.. The PBOC is also refraining from using traditional monetary-policy tools such as one it usually employed when the economy needed a push: cutting the amounts banks are required to hold in reserve, so they can make more loans. China now has one of the highest reserve-requirement ratios in the world

.. “China should tighten as little as possible so that it won’t become too expensive for Chinese firms to borrow money, but it needs to tighten enough to keep money at home,”

.. “The strategy is ultimately about buying time, but it’s a bridge to nowhere unless the authorities successfully deal with the debt problem and undertake reforms that allow for healthier growth.”

.. China’s financial system faces a liquidity shortfall—the gap between how much money is needed to meet China’s 6.5% growth target and how much is available—of as much as 13.1 trillion yuan this year.

.. the Federal Reserve Bank of St. Louis called China’s $1 trillion reserve decline “unprecedented” and said China must eventually choose some combination of tighter capital controls, tighter monetary policy or a devaluation to avoid further depletion.

Economists and investors warn that because of the effect of higher interest rates on companies with massive debt, Beijing may eventually have to give up currency control and let interest rates fall.

“The greatest risk in 2017,” says Pimco’s Mr. Frieda, “is that China is forced to choose in favor of financial-system stability at the expense of exchange-rate stability.”

China’s trilemma — and a possible solution

China faces the classic policy trilemma of international economics, that a country cannot simultaneously have more than two of the following three: (1) a fixed exchange rate; (2) independent monetary policy; and (3) free international capital flows.

..  An economy that is growing more slowly, and in which monetary easing is the principal macroeconomic response, is not an economy that offers high returns to domestic savers.[3] Consequently, Chinese households and firms who are able to do so are spurning yuan-denominated investments and looking abroad for higher returns. However, increased private capital outflows also constitute a flight from the yuan toward the dollar and other currencies; that, in turn, puts downward pressure on China’s exchange rate.

.. Chinese reserves have fallen over $700 billion over the past year and a half. With more than $3 trillion in reserves yet remainin

.. a big yuan devaluation would likely be deflationary for the rest of the world. (Indeed, fairly or not, a devaluing China could face accusations of waging a “currency war,” that is, weakening its currency to “steal” exports and aggregate demand from other countries.)

.. A second possibility for China would be to stop or reverse the process of liberalizing capital flows, making it more difficult for Chinese households and businesses to invest outside the country.

.. It would sacrifice some of the progress that China has made in opening up its financial system—which is itself a prerequisite for achieving China’s goal of making the renminbi an international reserve currency. Moreover, the horse may be out of the proverbial barn, in that the effectiveness of new capital controls in China would be uncertain.

.. the lack of a strong social safety net—the fact that Chinese citizens are mostly on their own when it comes to covering costs of health care, education, and retirement—is an important motivation for China’s extraordinarily high household saving rate.

.. Fiscal policies aimed at increasing income security, such as strengthening the pension system, would help to promote consumer confidence and consumer spending.

..  Unlike monetary easing, which works by lowering domestic interest rates, fiscal policy can support aggregate demand and near-term growth without creating an incentive for capital to flow out of the country.  At the same time, killing two birds with one stone, a targeted fiscal approach would also serve the goals of reform and rebalancing the economy in the longer term