Theory and practicability behind China’s new exchange rate policy
October 7, 2015
Chinese economic policy certainly has ideological and political power-conserving characteristics. However, more profound studies of Chinese economic policy also lead to the conclusion that important results from Western economic research more lately have been well integrated in quite a number of Chinese economic strategies and objectives. Evidence can, for example, be found, in the important reform package from the Central Committee’s Third Plenum in November 2013. Many of its 60 objectives and suggested policy changes seem to be well-anchored in economic research we are used to, dealing with the market economy, institutions, endogenous growth, the supply side, human capital, entrepreneurship, competition, etc.
“Impossible trinity”
Recently, another practical application from economic research was striking me. I am talking about China’s willingness to go more visibly for market-oriented exchange rates. We still have to see to what extent this new policy orientation will come true in reality. But the approach as such is interesting. It points at a phenomenon which is called “impossible trinity” by Western academic researchers.
Without getting too theoretical, one may say that research and experience have proved – look, for instance, at the Asian crisis from 1997/98 – that a central bank cannot meet the following three targets or conditions at the same time, instead just two of them:
- inflation target (or sovereign monetary policy)
- exchange rate target and
- free cross-border capital flows.
Formally, China has nowadays neither an inflation target nor free cross-border capital movements but is about to loosen its still existing kind of exchange rate target (vis-à-vis the U.S.dollar). Altogether, the phenomenon of “impossible trinity” cannot really be observed in the China of today. But what about the China of tomorrow? In a longer perspective, things may look like quite different.
I believe that China would like to be recognized as a country that can afford freely moving financial flows over its geographical borders (though it could take time to get there). Being considered – as it is currently the case – as a country with an underdeveloped financial sector is certainly not in line with all the positive visions and strategies Chinese political leaders have for the real economy. Without a modernized domestic banking system and a widely deregulated capital balance with mostly free cross-border money flows, China will be lagging considerably in international rankings. In other words: China really will make serious attempts in the next decade or so to achieve a system with more or less open financial borders. Whether this high ambition can really be verified or not, is quite a different question. But we know that preparation time for such an important move could be – and should be – quite long.
Inflation or exchange rate targeting
There is good reason to believe that China is working for an inflation target in the medium or longer term which induces – in general terms – an independent monetary policy. It is a well-known but uncomfortable fact for Chinese political leaders that their country particularly in the past decade has been affected by an increasingly unfavorable distribution of income. In times of very high GDP growth, such a development could be tolerated since the whole population was enjoying better economic conditions all the time – though urban residents were generally spoken clearly in the lead, very much supported by the booming housing sector. But relatively high inflation is really counteracting a fairer distribution of income. (I refrain here from applying the current, rather deflationary tendencies).
Today, however, we can predict that future Chinese economic growth will be more dampened. Thus, it will become more important to combat uneven income distribution. This objective can be supported substantially by an officially targeted, relatively low inflation rate. I would guess that China is working in such a direction.
Exchange rate targeting, however, would make these considerations and changes more or less impossible. Sovereign monetary policy cannot be conducted at the same time as a country prefers exchange rate targeting. But why should China in the medium- or long-term future choose exchange rate targeting at the expense of inflation targeting? Sure, certain future economic reforms will succeed – but other reforms and developments will fail and put pressure on the currency. Flexible exchange rates can usually tackle policy failures or losses of competitiveness more effectively than fixed exchange rates. Global markets can – hopefully – react more smoothly. Transparency tends to improve over time in a system with flexible exchange rates. Liberalized capital flows simply urge for more reliable information from China.
In this case, foreign and domestic Chinese investors will increase their pressure on Chinese political leaders and institutions for improvements of communication. In the longer run, we will probably know more exact details about real GDP growth, unemployment, bad loans of the banks, (local) government debt, etc. Disappointing statistical numbers will at certain points lead to challenges for the Chinese exchange rate.
In other words: China wants most probably to move (slowly) to a (managed) floating currency in order to meet possible occasional major moves or distortions of its exchange rate more flexibly than would be possible with fixed exchange rates – in line with conclusions from the “impossible trinity” which also includes strongly or completely abandoned cross-border capital controls.
Thinkable way forward
Scenarios for Chinese exchange rate policy may develop as follows when considering the “impossible trinity”.
Existing today:
# Inflation targeting? Yes, partly (not officially)
# Exchange rate targeting? Yes, recently somewhat loosened
# Cross-border capital control? Yes
=> no major conflict with “impossible trinity” (two conditions met at the same time)
In a couple of years:
Inflation targeting? Yes, more visibly
Exchange rate targeting? Yes, but decreasing
Capital cross-border control? Yes, but decreasing
=> still no major conflict with “impossible trinity” (but all three conditions more or less partly met)
In the longer run, 5-10 years from now:
Inflation targeting? Yes
Exchange rate targeting? No, or relatively limited
Capital cross-border control? No, or relatively limited.
=> no major conflict with “impossible trinity” if above-mentioned preconditions in place (should be a policy priority!);
improved conditions for “impossible trinity” – but not quite “clean”.
Result
According to the above-mentioned scenario, China will be most probably aiming at gradually meeting the characteristics and the conclusions from the “impossible trinity”- in a decade or so – more clearly than it seems to be the case today. The recent change of China’s exchange rate policy can possibly be regarded as an important step in the right policy direction. Today, however, we have no evidence that this recent change of exchange rate policy will be sustainable in the longer run. Hopefully, this will be the case – despite the fact that the appropriate velocity for certain structural financial policy changes (capital balance!)really can be discussed.
As the first alternative, I would plead for gradual and cautious changes when focusing on a future, workable “impossible trinity” – but without leaving the right, steadily reforming direction. This includes the two objectives inflation targeting and free cross-border capital moves and, consequently, the abolition of exchange rate targeting.
The second alternative – going for exchange rate targeting and free international capital from and to China – would take away the opportunity of an independent monetary policy. A terrible option!
The third alternative – maintaining capital controls and applying both an inflation target and an exchange rate target – would certainly not fit with a modern China.
Hubert Fromlet
Senior Professor of International Economics, Linnaeus University
Editorial board
