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

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.

Topics

Tags

Comments

Read article More on this topic More by this author

Blog Post

Alicia García-Herrero

Why is China finding it hard to fight the markets?

Sitting on a pile of debt, China’s only way out is to deleverage: more pain now for sustainable growth later.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: August 31, 2015
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The global trade slowdown puzzle

What’s at stake: This week’s data renewed concerns about developments in global trade as it showed for the last 6 months the biggest contraction in global trade since the end of the financial crisis. While cyclical factors may be at play, trade specialists have also advanced a host of structural explanations to explain the decline in the trade elasticity, ranging from a shift in the composition of trade to limits in the fragmentation of world production.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: August 31, 2015
Read about event More on this topic

Upcoming Event

7 
Sep
2015
15:15

Emerging markets and Europe: time for different relationships?

Now that Europe can focus on medium-term issues rather than crisis management, it is the right time to reassess relations with the emerging markets. While the US seems to be betting on Asia, through its famous “pivot” and TPP, Europe is far from having a clear strategy. This session will explore how to create a mutually beneficial relationship between Europe and the emerging markets.

Speakers: Muhamad Chatib Basri, Kemal Dervis, Alicia García-Herrero, André Sapir and Javier Solana Topic: Global Economics & Governance
Read about event Download PDF

Upcoming Event

8 
Sep
2015
09:00

Bruegel's Annual Conference

Bruegel's Annual Conference is a closed-door event with three panel discussions on banks and capital markets, growth perspectives, and monetary policy and central banking.

Speakers: Wassim Chourbaji, Zsolt Darvas, Anna Ekström, Luc Frieden, Otmar Issing, Joanne Kellermann, Rachel Lomax, Mario Monti, Alvaro Nadal, Jean Pisani-Ferry, Dirk Schoenmaker, Paul Sheard, Jean-Claude Trichet, Nicolas Véron and Guntram B. Wolff
Read article More on this topic More by this author

Opinion

Ashoka Mody

The Rolling Global Crisis Will Come Home

When productivity growth slows down, there are two choices: to invest in the future or to live within one’s means. Instead, policymakers preoccupied with short-term goals have sought easy growth elixirs and soothing words.

By: Ashoka Mody Topic: Global Economics & Governance Date: August 26, 2015
Read article

Blog Post

Guntram B. Wolff
Thomas Walsh

The dragon sneezes, Europe catches a cold

European stock prices, financial contagion and the trade exposure to China. How the turmoil in China’s stock market is affecting European stock markets through Europe's trade exposure to China

By: Guntram B. Wolff and Thomas Walsh Topic: Finance & Financial Regulation, Global Economics & Governance Date: August 26, 2015
Read about event

Upcoming Event

1 
Oct
2015
13:45

12th Asia Europe Economic Forum (AEEF)

This year's conference is entitled "Global Governance of Public Goods: Asian and European Perspectives".

Speakers: Chong-en Bai, Laurence Boone, Björn Conrad, Giancarlo Corsetti, Min Chang, Zsolt Darvas, Jos Delbeke, Jean-Francois Di Meglio, Andreas Esche, Joseph Francois, Kiyoto Ido, Sébastien Jean, Zhang Jun, Masahiro Kawai, Pascal Lamy, Il Houng Lee, Klaus Masuch, Yung Chul Park, Innwon Park, Guntram Wolff, Zhang Yan, Mitsutsune Yamaguchi and Naoyuki Yoshino
Read article More on this topic

Blog Post

Ashoka Mody

Delhi’s children deserve quality education

Money has not held up educational advancement in Delhi or in India more generally. Delhi’s education budget has risen steadily. And the worry is that the increased budget will once again be hijacked by glamorous but wasteful projects, including in higher education.

By: Ashoka Mody and Ritika Katyal Topic: Global Economics & Governance Date: August 4, 2015
Read article More on this topic More by this author

Opinion

Alicia García-Herrero

Europe must wake up before Iran falls into the arms of Russia and China

European leaders seem to have been caught somewhat off-guard by the Iran deal. The Greek saga alone could explain this. The problem is that other competitors —Russia and China— are one step ahead.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: August 3, 2015
Read about event More on this topic

Upcoming Event

5 
Oct
2015
09:00

Secular Stagnation in Europe and Japan

This is the 3rd conference in a series of events jointly organised by Graduate School of Economics, Kobe University and Bruegel

Speakers: Toshiki Jinushi, Guntram B. Wolff, Coen Teulings, Natacha Valla, Yoichi Matsubayashi, Masahiko Yoshii, Rainer Münz, Paul Swaim, Atsuko Ueda, Grégory Claeys, Naoyuki Yoshino, Juan F. Jimeno, Ryuzo Miyao, Xavier Ragot and Philipp Hartmann Topic: Global Economics & Governance
Read article More on this topic More by this author

Video

Video

Competitive gains in the Economic and Monetary Union

This event was organised in the frame of the 10th Anniversary of Bruegel. It brought together a panel of high level economic experts to discuss the competitive gains achievable through reinforcing the Internal Market and structural reforms.

By: Bruegel Topic: European Macroeconomics & Governance Date: July 22, 2015
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Restructuring in the US currency union

On June 28, the governor of the Commonwealth territory announced that it would not be able to repay its debt. Puerto Rico has since asked Congress to change the law to make the tools that U.S. municipalities can use to restructure their debt through Chapter 9 available to its territory. 

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: July 12, 2015
Load more posts