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 Global Economics & Governance Tags & Topics

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 article More by this author

Opinion

Alicia García-Herrero

‘Old China’ bad, ‘New China’ good: Growing divergence in Chinese corporate health

Divergence in debt levels and corporate health in China is growing, with many state-owned companies still stuck in the past and new industries such as tourism and healthcare overtaking the old ones. While fiscal and monetary stimulus may temporarily cover up the problems of companies in the old industries, a restructuring of these sectors seems inevitable.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: July 26, 2016
Read article

Blog Post

Alicia García-Herrero
DSC_0160

Assessing China’s post-Brexit globalisation strategy

As the world comes to terms with the result of the UK's Brexit referendum, what will it mean for China? The authors suggest that the short-term impact will be smaller for China than for other regions. But there are important considerations further ahead.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: July 19, 2016
Read article Download PDF More on this topic

Working Paper

cover

The China-Russia trade relationship and its impact on Europe

This paper analyses empirically how increasingly close trade relations between China and Russia might affect the European Union.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: July 14, 2016
Read about event More on this topic

Past Event

Past Event

China-Russia relations and their impact on Europe

The economic ties between China and Russia are growing. How will this relation affect Europe?

Speakers: Marek Dabrowski, Zsolt Darvas, Alicia García-Herrero, Vasily Gavrilov, Eric Girardin, Matteo Governatori, Iikka Korhonen, Heli Simola, Laura Solanko, Mingxi Sun and Jianwei Xu Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 21, 2016
Read article More on this topic More by this author

Blog Post

Marek Dabrowski

Core and periphery: different approaches to unconventional monetary policy

Compared with the ‘core’ of the world economy, emerging markets have limited room for manoeuvre when it comes to applying unconventional monetary policy measures.

By: Marek Dabrowski Topic: Global Economics & Governance Date: May 24, 2016
Read about event More on this topic

Past Event

Past Event

Will China's slowdown bring headwinds or opportunities for Europe and Central Asia?

After years of rapid growth, China's GDP is expanding more slowly. There are fears about the global impact, but could there also be opportunities for Europe and Central Asia?

Speakers: Maurizio Bussolo, André Sapir and Jianwei Xu Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: April 29, 2016
Read article More on this topic More by this author

Opinion

Alicia García-Herrero

Debt, not reserves, to constrain China’s cross-border buying spree

Despite an $800 billion drain on China’s foreign reserves over the last 20 months, Chinese firms have been on a buying spree that has only accelerated since the beginning of the year.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: April 27, 2016
Read article More on this topic More by this author

Opinion

Alicia García-Herrero

Chinese banks: the way forward

Despite the economic downturn the Chinese banking system continues its expansion. Concerns are rising about the institutions' strenght, as bad loans continue to grow. Heightened competition among fintech companies and low net interest margin are other causes for concern.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: April 19, 2016
Read article More on this topic

Opinion

fratzscher-03
Reint_Gropp_m
p2-Kotz
jan-pieter-krahnen
odendahl-june14-1409577172
Beatrice Weder di Mauro
Guntram B. Wolff

Mere criticism of the ECB is no solution

What would happen if the ECB failed to respond to the excessively low inflation and the weak economy? And what economic policy would be suitable under the current circumstances, if not monetary policy?

By: Marcel Fratzscher, Reint Gropp, Hans-Helmut Kotz, Jan Krahnen, Christian Odendahl, Beatrice Weder di Mauro and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 10, 2016
Read about event More on this topic

Past Event

Past Event

Seven Years after the Crisis: Intersecting Perspectives

The global economy is still marked by the effects of the financial crisis. Advanced and emerging economies display divergent narratives in the post-crisis period, but what can they learn from each other?

Speakers: Abdelaziz Ait Ali, Karim El Aynaoui, Hakim Ben Hammouda, Samir Benmakhlouf, Dominique Bocquet, Marek Dabrowski, Uri Dadush, Laura El-Katiri, Karim El Mokri, Iñigo Fernandez de Mesa, Manfred Hafner, Malika Laasri Lahou, Ted Moran, Mehmet Öğütçü, Nicolò Russo Perez, Marco Raganella, Ahmed Rahhou, Stefano Sacchi, Edward Scicluna, Simone Tagliapietra, Heliodoro Temprano Arroyo, Guntram B. Wolff, Georg Zachmann, Daniela Zampini, Marie Francoise Marie-Nelly and Chiedu Osakwe Topic: Global Economics & Governance Location: Rabat, Morocco Date: March 31, 2016
Read article More on this topic

Blog Post

Pia Hüttl
Alvaro Leandro

Helicopter drops reloaded

What’s at stake: Central banks have recently been scaling up their unconventional monetary policy measures. Discussions about helicopter money seem to be getting ever louder. We review the theoretical discussions, the effectiveness of tax-rebates and legal and political complications

By: Pia Hüttl and Alvaro Leandro Topic: European Macroeconomics & Governance Date: March 14, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

ECB TLTRO 2.0 - Lending at negative rates

On Thursday, the ECB surprised observers by announcing a new series of four targeted longer-term refinancing operations (TLTRO II) to be started in June 2016. The incentive structure of the programme has changed: on one hand, this TLTRO II could be the first case of lending at negative rates; on the other hand, the link with lending to the real economy might have been weakened.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: March 11, 2016
Load more posts