The article (Emons) analyses a number of macro environmental phenomena that may soon prompt the Chinese government to completely deregulate the Yuan – despite policymakers’ reluctance to do so. Emons points out that officials’ efforts to reduce the country’s debt without approving any measures that may destabilize the domestic market have resulted in yields on short-term maturities exceeding those on long-term debt for the first time. Assuming that sooner or later the Chinese government will allow the Yuan to become a market-driven currency, the reporter argues that if liberalization is not done correctly, greater access to China’s capital markets may lead to an increase debt, as well as massive capital outflows.
In order to gain a deeper understanding of the forces affecting the Chinese yuan, it is advisable to investigate the way in which demand and supply are managed by the Chinese government in such a way to prevent the national currency from responding to changes in the market. Unlike the Yuan, free-floating currencies such as the U.S. Dollar, the Euro and the British Pound are influenced by fluctuations in supply and demand which eventually determine their EP (i.e. their Equilibrium Point) and, therefore, their price.
The diagram below shows how the Chinese government has been managing the Yuan in such a way to keep its value fixed. In a free market, the price of the Yuan – or any other currency for that matter – would change depending on its quantity / availability, thus resulting in continuous fluctuations. In this regard, the law of demand and supply states that when demand exceeds supply, the price of any given asset tends to go up; on the other hand, when supply exceeds demand, prices tend to go down. Graph 2 clearly shows that while the value of the Yuan should coincide with its Equilibrium Price – which is of course determined by changes in demand and supply – China’s State Administration of Foreign Exchange prefers keeping the value of the Yuan below its Equilibrium Price, thus making it way cheaper than it should be.
Graph 1. How the Chinese government regulates / manipulates the Chinese Yuan
The article goes on by comparing China’s debt position to that of other Asian nations. Following a significant surge in corporate issuance, foreign investors currently hold a significant percentage of the country’s debt, meaning that if financial liberalization intensifies, corporate debt issuance may grow even further to meet foreign demand. The downside of all this is that corporate issuance of domestic debt may fall due to China’s complex regulatory environment. Considering that nearly half of the country’s debt is held by domestic funds and non-bank financial intermediaries, the negative effects of a decline in issuance would only partially be mitigated by demand from foreign investors. Provided that a credit contraction would almost certainly slow down the Chinese economy, Emons argues that a slower economy should pressure the Chinese government to deregulate the Yuan in order to attract foreign capital. By transitioning to a market-driven currency exchange system, China would obtain three noteworthy advantages. First of all, it would put a stop to the ongoing decline in foreign currency reserves; second of all, it would maintain full control over the nation’s monetary policy – which has always been one of Beijing’s major concerns; last but not least, it would finally put an end to political criticism of its manipulative monetary policy.
In conclusion, it is only by deregulating the Yuan that the Chinese government will finally be able to liberalize capital markets and minimize the potentially devastating effects of a credit contraction by letting foreign capital flow into its economy.
- Emons, Ben. China’s Deleveraging Puts the Yuan Closer to a Free Float. Bloomberg, 23 May 2017. https://www.bloomberg.com/view/articles/2017-05-23/china-s-deleveraging-puts-the-yuan-closer-to-a-free-float. 7 Sep 2017.