Blog Post

China’s financial liberalisation: interest rate deregulation or currency flexibility first?

In this follow-up, I argue that on top of these structural and institutional factors, there are also three short-term cyclical considerations in favour of a strategy of accelerating currency flexibility ahead of full interest rate liberalisation in China.

By: Date: May 19, 2014 Topic: Global Economics & Governance

In my article last Tuesday, I considered three institutional factors that would tend to favour a strategy of freeing the renminbi (RMB) exchange rate ahead of fuller interest rate liberalisation in China. In this follow-up, I argue that on top of these structural and institutional factors, there are also three short-term cyclical considerations in favour of a strategy of accelerating currency flexibility ahead of full interest rate liberalisation in China.

First, the low exchange rate volatility of the RMB complicates China’s tasks of interest rate liberalisation, monetary management and financial stability. RMB volatility has been extremely low, currently standing at one third to one fifth of that experienced by other major emerging-market currencies (Graph 1), and making the RMB one of the most attractive carry targets among major emerging-market currencies.

Graph 1: Historical volatility of selected EM currencies (%)

Note: one-month historical vol of the dollar spot rates, 3-month moving average.

Source: Datastream.

This, together with a sizable positive carry, has given rise to attractive risk-adjusted returns on RMB carry trading, enticing more speculative short-term capital inflows into China. This adds challenges to the tasks of both exchange rate and interest rate liberalisation. Thus the RMB needs to first become meaningfully more flexible (and thus less managed) before further interest rate deregulation, which at the moment would be much less beneficial than many have claimed.

Second, should deregulations lead to a further rise in domestic deposit rates, it would further widen the positive carry, unless the US Fed’s tapering and policy normalisation suddenly accelerate. The 3-month SHIBOR (Shanghai Interbank Offered Rate) currently stands at 4-5 percent, while the 3-month US$ LIBOR is only 0.25 percent. So a more volatile RMB and a steadier local interest rate would make more sense at this juncture, because they would deter speculative carry trade inflows.

Third, a generalised trend of higher domestic interest rates in the context of declining inflation and weakening domestic demand is also bad for the Chinese economy, potentially undermining political support for financial reform. A combination of debt-hungry local government and interest rate liberalisation would likely lift real rates, which makes little sense, as China’s domestic demand weakens further.

For the past few years, the real policy rate of the PBC has been the highest among the world’s major central banks (Graph 2). While the G3 central banks have been aggressively pushing real rates into negative territory to stimulate corporate investment and consumer spending, it seems doubtful that rising and positive real interest rates would help to further pry open the Chinese consumers’ wallet. Indeed, excess saving ought to put downward, not upward, pressure on real interest rates in China.

Graph 2: Real policy rates at major central banks (%)

Note: real rate is defined as policy rate less CPI inflation. The PBC policy rate is the official one-year deposit rate.

Sources: Datastream.

By contrast, the movement of the RMB is likely to become more two-way. The real effective RMB has appreciated 40 percent over the past decade and even gained 20 percent vis-a-vis the average of the top 25 emerging market peers over the same period (Graph 3). The RMB might have become more fairly valued nowadays. Hence freeing the RMB exchange rate would generate relatively less deflationary headwind for the Chinese economy.

Graph 3: REER: the renminbi vis-a-vis the average of 25 major EM currencies

Note: AVE25EM is a simple average of REERs for the top 25 emerging market currencies other than the RMB. December 2007 = 100.

Source: Bruegel.

Thus on balance, there are a number of good reasons, both cyclical and institutional, for China to proceed first and faster with greater exchange rate flexibility before fully deregulating the official bank deposit rates. China urgently needs a more flexible currency and would benefit from a steadier interest rate. Faster exchange-rate liberalisation would better complement both economic growth and interest rate deregulation.

To be clear, I am not advocating a halt to domestic interest rate liberalisation until free floating is achieved, but instead I am simply making a case that currently, greater currency flexibility should urgently accelerate ahead of full interest rate deregulation. Indeed, both the interest rate and the exchange rate should be much freer before further big breakthroughs in China’s capital account opening. But that is a topic for another day.

Assistance by Simon Ganem is gratefully acknowledge


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read about event More on this topic

Past Event

Past Event

EU - CELAC Economic Forum - Channels for a joint future

On 11 October Bruegel together with GIGA and Real Instituto Elcano will organise a conference on relations between the EU and the Community of Latin American and Caribbean States.

Speakers: Paola Amadei, Angel Badillo, Paulo Carreño King, Linda Corugedo Steneberg, Gonzalo de Castro, Gonzalo Gutiérrez, Bert Hoffmann, Edita Hrdá, Ramón Jáuregui, Emilio Lamo de Espinosa, Eduardo Levy Yeyati, Gabriel Lopez, Enrique Medina Malo, Maryleana Méndez Jiménez, Luicy Pedroza, Mario Pezzini, Mario Soares, Everton Vargas, Dylan Vernon and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: October 11, 2017
Read article More on this topic More by this author

Blog Post

Long-term growth potential, or dead in the long run?

By linking growth with both employment and the imperative for India to hold its own with China for strategic autonomy, Prime Minister Modi has brought sustainable, high quality, inclusive economic growth to the centre of political discussion, which is where it rightfully belongs.

By: Suman Bery Topic: Global Economics & Governance Date: October 5, 2017
Read article Download PDF

External Publication

European Parliament

The single monetary policy and its decentralised implementation: An assessment

This paper assesses the decentralised implementation of monetary policy by the Eurosystem in terms of its transparency, efficiency and simplicity. Compared to the Fed, the Eurosystem seems to have higher staff numbers and operational costs for similar tasks.

By: Francesco Papadia and Alexander Roth Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: October 4, 2017
Read article More on this topic More by this author

Blog Post

Ukraine’s oligarchs are bad for democracy and economic reform

Ukraine’s late and incomplete economic reform created a class of super-wealthy oligarchs who now stand in the way of further liberalisation. The oligarchs’ oversized influence only deepens public distrust in a structurally weak political system. Nevertheless, Ukraine is making some attempts to uproot corruption and the next steps are clear.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: October 3, 2017
Read about event More on this topic

Past Event

Past Event

Europe and Japan: Monetary policies in the age of uncertainty

The 5th Bruegel - Graduate School of Economics, Kobe University conference will focus on monetary policy.

Speakers: Kosuke Aoki, Ulrich Bindseil, Grégory Claeys, Zsolt Darvas, Ester Faia, Lex Hoogduin, Martin Hellwig, Miles Kimball, Eric Lonergan, Benoît Mojon, Tamotsu Nakamura, Marianne Nessén, Athanasios Orphanides, Wataru Takahashi, Tokiko Shimizu and Guntram B. Wolff Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: October 2, 2017
Read article More on this topic More by this author

Blog Post

Chinese banks: An endless cat and mouse game benefitting large players

As deleveraging moves up in the scale of objectives of the Chinese leadership, banks now face more restrictions from regulators. As a result, banks have been very creative in playing the cat and mouse game in front of evolving regulations.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 26, 2017
Read about event More on this topic

Past Event

Past Event

14th Asia Europe Economic Forum (AEEF)

The 14th Asia Europe Economic Forum will be held in Seoul on 20-21 September 2017.

Topic: Global Economics & Governance Location: Seoul, Korea Date: September 20, 2017
Read article Download PDF

Policy Contribution

Capital Markets Union and the fintech opportunity

Fintech has the potential to change financial intermediation structures substantially. It could disrupt existing financial intermediation with new business models empowered by intelligent algorithms, big data, cloud computing and artificial intelligence. Policymakers need to consider four questions urgently: Develop a European or national fintech market? What regulatory framework to pursue? Should supervision of fintech be exercised at the European level? What is the overall vision for the EU’s financial system?

By: Maria Demertzis, Silvia Merler and Guntram B. Wolff Topic: Finance & Financial Regulation, Innovation & Competition Policy Date: September 15, 2017
Read article More on this topic More by this author

Opinion

Is China Deleveraging? Too Early to Cheer

This blog post was originally published on BRINK “Deleveraging” is the new buzzword in China. The leadership clearly wants to scale back its epic borrowing, but it is not necessarily ready to pay the price for it, namely, the price of having less support for growth. The question is whether the recent efforts of China’s leadership to […]

By: Alicia García-Herrero Topic: Global Economics & Governance Date: September 13, 2017
Read article More by this author

Podcast

Podcast

Surprising priorities for Europe and China

Bruegel’s Alicia García-Herrero and Robin Niblett of Chatham House discuss a new joint report on EU-China relations. How easy was it to find common ground with Chinese partners? And what should be the priorities for economic cooperation between Europe and China?

By: The Sound of Economics Topic: Global Economics & Governance Date: September 13, 2017
Read about event More on this topic

Past Event

Past Event

EU-China economic relations: looking to 2025

This event will see the launch of a report on EU-China relations and discuss issues such as trade and investment, industrial cooperation and innovation and global governance

Speakers: Victor Chu, Ian Davis, Alicia García-Herrero, Dame Clara Furse, Tony Graziano, Anatole Kaletsky, K.C. Kwok, Lawrence J. Lau, Ina Lepel, Hanna Müller, André Sapir, Robin Niblett, György Szapáry, Jean-Claude Trichet, Zhang Yansheng, H.E. Ambassador Yang Yanyi, Liu Xiangdong, Gunnar Wiegand, Guntram B. Wolff, Huang Ping and Elena Flores Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 13, 2017
Read article Download PDF More on this topic

Book/Special report

EU–China Economic Relations to 2025. Building a Common Future

The EU and China, as the world’s second and third largest economies, share a responsibility in upholding the rules-based, global free trade system and other forms of multilateral cooperation, especially on combating climate change. This report sets out the main conclusions of a research project between European and Chinese think-tanks, which addresses the prospects for the EU–China economic relationship. A Joint Report by Bruegel, Chatham House, the China Center for International Economic Exchanges and the Institute of Global Economics and Finance at The Chinese University of Hong Kong.

By: Alicia García-Herrero, K.C. Kwok, Tim Summers, Liu Xiangdong and Zhang Yansheng Topic: Global Economics & Governance Date: September 13, 2017
Load more posts