China's Exchange Rate - A Look at the Chinese Shines

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1 (August 2015) An Examination of the Chinese Economy from the Perspective of Dealing Rooms A roadmap for the internationalization of the Chinese yuan and the impact of stock price depreciation Osamu Yoshida Treasury Division Mizuho Bank (China) Ltd. (osamu.yoshida@mizuho-cb.com) 1. Introduction This year is memorable for the Chinese yuan. It was back in July 21, 2005 when the floating exchange rate system managed by Authority was introduced for the Chinese yuan, which makes this summer the 10th anniversary. In 2005, the Japanese government introduced the cool biz campaign, and Disneyland opened in Hong Kong. Looking back on the past 10 years since 2005, this article mainly examines the deregulation and internationalization of the Chinese yuan. It should be noted, however, that the contents of this article reflect the author s personal view to some extent. 2. Chinese yuan exchange rate for the past 10 years Graph 1-1 shows the exchange rate of the Chinese yuan (against the U.S. dollar) since July 2005, when the current managed floating exchange rate system was introduced. It can be said that this is, in general, a history of Chinese yuan appreciation. However, it is also widely recognized that the Chinese yuan has not always been appreciating in recent years, while China faces risks of an economic slowdown, even while maintaining a high growth rate (see Graph 1-2). Graph 1-1: U.S. dollar/chinese yuan exchange rate (long-term) Graph 1-2: U.S. dollar/chinese yuan exchange rate (short-term) July 21, 2005: The Chinese yuan started trading against the U.S. dollar with a floating rate. The Chinese yuan appreciated approximately by 17.5% in three and half years. The exchange rate stopped fluctuating temporarily, due to the Lehman Shock. The Chinese yuan continues to appreciate, albeit moderately From June 2010, the Chinese yuan re-started trading against the U.S. dollar with a floating rate. The general trend shows the appreciation of the Chinese yuan. However, the exchange rate started fluctuating in both directions in recent years. Source: Bloomberg Source: Bloomberg Chinese monetary authorities, such as the People s Bank of China (PBOC), have emphasized that the Chinese yuan exchange rate should fluctuate in both directions, and the exchange rate has been

2 controlled as such as the ahthority said. We would like to consider which direction the foreign exchange management system as an important field of Chinese monetary policy is going to in next few year. 3. Environment surrounding the Chinese yuan In order to examine the future prospects for China s foreign exchange management system, this section will summarize the current environment surrounding the Chinese yuan. (1) Change in the global position of China The military expenditures of China amounted to USD 214 billion in 2014 (according to an estimate made by the Stockholm International Peace Research Institute), and this is the second largest in the world following the U.S. (and approximately 2.5 times larger than Russia, which ranks third). In terms of economy as well, the real GDP of China became the second largest in the world in 2010, exceeding that of Japan. Thus, a lot of changes have come to pass since 2005, when China introduced the current floating exchange rate management system. It is essential for key currencies to have military and economic support (which leads to political power, in a large sense). It is thus considered that, under the current conditions, the Chinese yuan already has the power to be trusted as a settlement currency in the Asian region, even if it cannot be an international key currency just yet. (2) Asian Infrastructure Investment Bank (AIIB) and the One Belt, One Road Strategy As the factory of the world, China has recorded more than USD 2.2 trillion as its trade surplus in the past 10 years since China also currently has more than USD 3.6 trillion in its foreign currency reserves, which is approximately three times larger than those of Japan (see Graph 2). Based on the military and economic powers that have already been mentioned above and on the large amount of foreign currency reserves, the Chinese yuan is certainly expected to, with the AIIB (founded in June this year), establish an economic and currency zone independent of the U.S. dollar, in tandem with the One Belt, One Road strategy. Graph 2: Foreign currency reserves of Japan and China (Unit: USD billion) 4,500 4,000 3,500 China Japan 3,000 2,500 2,000 The foreign currency reserves of China are approximately three times larger than those of Japan. 1,500 1, / / / / / / / / / / /01

3 (3) Trilemma in the international monetary system Trilemma in the international monetary system refers to a theory such that it is impossible to achieve (1) an independent monetary policy, (2) a fixed foreign exchange system, and (3) free capital movement, at the same time. Conversely, if one of the above three is abandoned, the remaining two goals can be achieved. It can be said that so far China has abandoned (3) (through total restriction on capital movement) in order to achieve (1) and (2). However, since 2005, China has been gradually moving the foreign exchange rate (though still managing it) and has been deregulating the capital market, albeit slowly and gradually. In near future, a large amount of capital is expected to move in and out of China because of the AIIB and the One Belt, One Road Strategy, in an unrestricted manner. Thus, the foreign exchange fluctuation range needs to be wider. With the above factors, it seems that it is natural for the Chinese yuan to shift to a free-floating exchange rate system for a settlement currency in Asia soon, but will it come true? 4. Roadmap for the internationalization of the Chinese yuan and the impact of stock market depreciation When monetary policy reforms are mentioned in China, they always repeat the expression very soon. On the other hand, the official outlook by the Chinese government and the PBOC has always been that there is no clear timeframe for the internationalization of the Chinese yuan. However, it is true that there exists a vision for Shanghai becoming an international financial center by 2020, along with a report on the deregulation of capital transactions, 我 国 加 快 资 本 账 户 开 放 的 条 件 基 本 成 熟, in Chinese ( General Fulfillment of Conditions for Accelerating the Reform of Capital Transactions ), released by the Financial Survey and Statistics Department of the PBOC (hereinafter referred to as the Financial Survey and Statistics Department Report ), while saying that there is no timeframe. The Financial Survey and Statistics Department Report was released in February 2012, and the report shows the time axis for the reform on main monetary services as short term (1 3 years), medium term (3 5 years), long term (5 10 years), and ultra-long term (over 10 years) (see Figure 1). According to this time axis, capital movement for bond and stock investment as well as real estate investment would also be deregulated by As the target year for Shanghai to become an international financial center is 2020, these issues can be seen as one of the key goals for the government under President Xi Jinping (his term of office is to be until 2022 [for two terms, 10 years]).

4 Figure 1: Time axis for capital regulation Short term (1 3 years): To deregulate processes related to direct investment that are backed by actual transactions and to promote foreign investment by corporations ( Go Global ) Medium term (3 5 years): To deregulate processes related to commercial credits that are backed by actual transactions and to promote the internationalization of the Chinese yuan Long term (5 10 years): To develop the monetary market; to be the source, not the destination, of the capital flow; to reform the real estate, stock, and bond markets; and to shift gradually from quantitative management to price management Reform stages: I, II, III, and IV refer to short term (1 3 years), medium term (3 5 years), long term (5 10 years), and ultra-long term (over 10 years), respectively. Capital transaction type Direct investment settlement Risks Reform stage Capital transaction type Risks Reform stage Low based on investment actual demand I: Short term Financial institution credit High based on derivative needs IV: Ultra-long term Commercial credits Low based on trade actual demand II: Medium term Portfolio investment High based on difficulty in management and supervision IV: Ultra-long term Bond securities Medium based on real economic needs III: Long term Financing facilities such as collaterals and securities Same as above IV: Ultra-long term Stock securities Same as above III: Long term Personal capital transaction Same as above IV: Ultra-long term Real estate Same as above III: Long term Derivatives, etc. Same as above IV: Ultra-long term Money market High based on derivative needs IV: Ultra-long term Source: Compiled by the author based on the website of the People s Bank of China However, this project was interrupted by the trend in the major stock markets in China. As has already been reported by the media, stock prices depreciated sharply from the middle of June to the beginning of July this year (see Graph 3). In addition to that, the Chinese government intervened in the market using both quantitative and qualitative tools, in order to stop stock prices from falling further (see Figure 2). It cannot be denied that the market functions were weakened as a result of such measures, though the depreciation of stock prices was slowed down. Graph 3: Chinese stock market capitalization/shanghai Stock Exchange Composite Index 70,000 60,000 Stock market capitalization in China (right axis, CNY billion) Shanghai Stock Exchange Composite Index (left axis) 7,000 6,000 50,000 40,000 Stock prices have appreciated by approximately 25% in the past year or so after June ,000 4,000 30,000 3,000 20,000 From June 12, 2015 to July 8, 2015, stock prices fell by approximately 32%. 10, / / / / / / / / /07 2,000 1,000 Source: Bloomberg Figure 2: Key measures for the stock market as taken by the Chinese monetary authorities June 27 July 1 July 3 July 4 July 5 As needed The PBOC lowered the regulated interest rate. Trust transactions were deregulated. The level of monetary funds for Chinese securities was raised. Major securities companies were instructed to purchase ETFs. Approved IPOs were temporarily postponed. The PBOC expressed its intention to provide liquidity in the market for the Chinese securities market. The sale of almost half of the listed securities was halted. Source: Compiled by the author based on various media reports

5 It is difficult to measure clearly how much impact the stock price depreciation had on the process of the internationalization of the Chinese yuan. However, the stock market in which the Chinese government intervened this time was one of the areas to be reformed in the long term (5 10 years), i.e., in , according to the Financial Survey and Statistics Department Report. Even though the sharp depreciation of stock prices was stopped for the time being, the measures taken by the government, such as instructions given to securities companies to purchase ETFs (Exchange Traded Funds), restrictions on the listing of approved IPOs (Initial Public Offerings), liquidity provided by the central bank, and the halt in the trading of listed stocks, show that China is far from monetary reform and the deregulation of capital transactions. Furthermore, it can be said that such measures made overseas investors dubious of market reforms. It is possible that the reform of the stock and bond markets and the actual functioning, which is considered to be the key issue regarding capital transaction restrictions for the next five years, will be delayed by another five years or so. In addition, based on the trilemma in the international monetary system, control over the foreign exchange market will persist as long as capital movement is restricted. Furthermore, it can be even said that the process of establishing the Chinese yuan economic zone based on the AIIB and the One Belt, One Road strategy has been impacted by the recent depreciation of stock prices in China. Thus, the recent depreciation of stock prices and the measures taken by the Chinese authorities to deal with the situation had substantial impact. Even though it has been 10 years since the current managed foreign exchange rate system was introduced, the next 10 years are expected to be even more difficult. 5. Conclusion In China, there is the expression, meilinzhike (a plum tree forest stops thirst), which means makeshift. The most famous use of this was probably by the character, Cao Cao, in the novel, Romance of the Three Kingdoms. In one chapter of the book, Cao Cao s army became lost, and the soldiers were suffering from thirst. Cao Cao then told the soldiers about the many sweet & sour plums that can be found in the plum tree forest. Hearing this, the mouths of the soldiers were watering at the thought, which quenched their thirst, even for a moment. The thought of plums does little to mitigate the summer heat of Shanghai; it is truly tiring every year. However, despite the sweltering temperatures, it is a pleasure to relay useful information to you all from a local office.

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