How Does China Control Exchange Rates?

For many investors, China and its economic policies have appeared to be at the epicenter of major shifts in the global economy—shifts with commodities prices and global commerce, stock market fluctuations, and foreign exchange levels.

As the main engine of trade in the dynamic economy of Asia, China and its currency (the yuan) have exercised growing roles in that region and across the globe. As it struggles to evolve from an underdeveloped emerging market to a central player in the global economy, China has experienced growing pains and faced policy decisions that have frequently sent shockwaves through markets around the world.

Gradual alterations and an evolution in the country's foreign exchange policies have been central to its attempts to ease into a position as a leading world economy while promoting the yuan as a global reserve currency.

Easing A Fixed Rate

Unlike many of its international trade partners (who allow the values of their currencies to float freely against others), China has a strictly controlled currency policy where it regulates trading activity and tries to control daily movements of the yuan on the forex market.

In order to tame economic instability, China fixed its exchange rate in 1995 at slightly more than 8 yuan to the United States dollar and maintained that peg until July 2005, when it made a move toward a liberalisation of its currency policy by introducing a narrow trading band. Over the past decade, the government has gradually allowed the trading band to widen, starting at +/-0.3% and finally reaching +/-2% by March 2014.^[1]

In August 2015, China took a step further by allowing its currency to devalue outside of the previous trading band. In its policy move, the government said it would consider the previous day's trading in the establishment of the currency rate, effectively considering the influence of the market.

In a statement, China's government said that "henceforth the mid-point of an expanded 2% band within which the currency can move on any single day would be based on the previous day's closing value." It also said the currency rate would be determined by "demand and supply conditions in the foreign exchange markets and the movement of major currencies." With this change, the country was seen moving its policy from a rigid band and toward a floating currency rate.^[2]

Managing The Currency: Market Intervention

China has maintained strict rules for individuals and banks holding foreign currency, and thus the currency is not yet considered to be fully convertible. Investors who exchange dollars or other foreign currency for yuan must sell them directly to China's central bank, which incorporates them into the country's foreign reserves. The government then prints local money for use by individuals, companies and banks.^[3]

When China began to open its economy to foreign investment in the 1980s and '90s, the country began to accumulate large amounts of dollar reserves. It currently holds the world's largest stockpile of reserves, having amassed an estimated US$3.2 trillion.^[4]

China has customarily used a portion of its reserves to influence the value of its currency through foreign exchange market interventions. To strengthen the yuan, the Chinese central bank sells foreign currency reserves (typically dollars) into the market. On the other hand, if the country wants to weaken its currency, it uses its local currency to buy foreign currency.^[5]

To intervene, the government can buy or sell currency through its interbank market, where the central bank, the People's Bank of China, maintains "designated foreign exchange banks" to operate on its behalf for onshore spot market transactions.^[6]

A large part of China's reserves are denominated in U.S. dollars and are invested in U.S. treasury bonds, which are deemed to be a safe haven for capital among major central banks around the globe. It is estimated that China is the largest single nation holder of U.S. bonds, with approximately US$1.25 trillion of these securities.^[7]

The central bank also has other instruments at its disposal, such as derivative contracts to influence the market and the value of the currency. It has used a combination of these instruments to bring more sophistication to its management of currency rates and foreign reserves. The advantage of using these instruments is that the bank doesn't have to sell its dollar supplies immediately. This can slow the depletion of its reserves, thus maintaining market confidence in its ability to intervene in the future.^[8]

Despite alterations in currency policy, some analysts estimate that the yuan may still be overvalued by as much as 10%, causing the market to bid the currency lower. As part of its effort to shore up the yuan, China has begun selling some of its stockpile of U.S. Treasury bonds.^[9]

Monetary Policy

Monetary policy is another long-term mechanism that affects China's currency inflows and prices. Following its initial liberalisation of currency policy in 2005, the Chinese central bank had maintained higher interest rates. In 2014, however, the bank began easing local interest rates to counteract a slowing economy. The rate easing had the effect of discouraging foreign currency inflows into the economy and subsequently brought pressure for the weakening of the yuan.^[10]

In addition to altering interest rates, the government can alter reserve requirements within the domestic banking system, freeing up the supply of local money available to the market.^[11]

Within The Band

While China currently maintains its currency rate within a controlled band that fluctuates according to market demand, some market participants have noted the central bank has at times signaled its preferences for near-term currency levels through its interbank foreign exchange system. In particular, the government has been suspected of occasionally using its automatic price-matching system, which is a centralised computer system used to identify bids, to make trades on the extreme ends of market trading ranges.^[12]

Under the current system, the currency rate cannot fall outside of the established 2% band during any given session. An official re-adjustment of the mid-point rate for the trading band is announced by the country's Foreign Exchange Trading Center at 9:15 a.m. each day, Shanghai time.

Evolving Currency Policy

As the yuan has not been made fully convertible, China has faced difficulties maintaining strict control over its currency levels while seeking to adapt to shifts in the global economy and maintain economic growth.

The country has sought to integrate itself further into the global economy by aiming to promote the yuan as an international reserve currency, similar to the dollar, the British pound, euro, and the Japanese yen. This is part of an effort to construct a stable economy for its growing population of 1.4 billion. The currency's internationalisation has involved seeking the yuan's inclusion in a basket of currencies making up the International Monetary Fund's "Special Drawing Rights."

The Special Drawing Rights, or SDRs, are a virtual currency that can be lent to central banks to cover for balance of payments shortfalls. In December 2015, the IMF said that it was prepared to begin including the yuan in its basket of currencies backing the SDR as soon as October 2016. While this is a step forward for China, the inclusion doesn't guarantee that world governments will be inclined to use the currency for their own reserves.^[14].

Currency Control: What's Ahead?

Despite its ambitions, speculation has arisen whether China will have the political will to follow through with its plans to further ease currency restrictions and risk losing too much control over its economy. Because of its tightly managed currency policies, the country has faced what has come to be known as the "Impossible Trinity," or "Trilemma." First described by economist Robert Mundell in the 1960s, the condition arises out of a country's inability to maintain complete control over its currency and monetary policy while allowing free movement of capital necessary for full insertion into the global economy.

China has not set a timeline for allowing its currency to float freely against others, but IMF officials have said they hope that such a move could happen "within two or three years" with the country's easing of its currency band policy in 2015.^[15]

Slowing Economy

With a slowdown in the Chinese economy following high levels of growth seen in the last decade and investor doubts about the economy's strength, the yuan has weakened. This has forced the government to step in to sell reserves. Although it holds large stockpiles of dollars, China has been forced to sell US$100 billion per month (or more) to defend the level of the yuan. This has caused some to believe the country may be persuaded to allow a free float of its currency sooner than imagined.^[16]