Victor Shih is an associate professor of political economy and has published widely on the politics of Chinese banking policies, fiscal policies and exchange rates. He was the first analyst to identify the risk of massive local government debt, and is the author of “Factions and Finance in China: Elite Conflict and Inflation.”
Prior to joining UC San Diego, Shih was a professor of political science at Northwestern University and former principal for The Carlyle Group.
Shih is currently engaged in a study of how the coalition-formation strategies of founding leaders had a profound impact on the evolution of the Chinese Communist Party. He is also constructing a large database on biographical information of elites in China.
He holds and Ph.D in Goverment from Harvard University and B.A. in East Asian Studies from George Washington University.
Could you give us a quick overview of the recent fluctuations in the Chinese currency and the Chinese government’s policies on the exchange rate and capital control?
After August 2015, China devalued its currency and switched to a more flexible peg. Instead of a fixed peg to the dollar, China began to take into account the actual market demand for the dollar and the renminbi, using trading values from the day before when setting the exchange rate for the coming day. That mechanism led to about a 4 percent rapid devaluation of the renminbi, which triggered a crisis of confidence and a massive wave of money out of China. Within the span of one year, around $1 trillion left China’s foreign exchange reserves. Then in the second quarter of 2016, China imposed draconian capital control. It backed away from the more flexible market-based exchange rate mechanism, in favor of a more rigid mechanism, in order to shore up confidence in the renminbi. This capital control consisted of limitations on the movement of currency from a domestic account to a foreign account and limitations on the purchasing of foreign goods with Chinese currency. Due to this capital control, the more fixed exchange rate mechanism, and the global weakness of the dollar, the renminbi has appreciated very aggressively in the last 6 months. It fell as low as 7 renminbi to the dollar, but in recent months it has returned to about 6.4 to the dollar. Now the exchange rate is around 6.6 to the dollar.
The Chinese currency, the renminbi, appears to have stabilized after more than a year of decline. What are the reasons for its rebound? Should Beijing’s tightened capital control get most of the credit? Is the rebound sustainable?
It was a combination of a couple of things that stabilized the renminbi. Part of the answer relates to capital control, particularly for companies and especially wealthy individuals. For companies that had accounts in Hong Kong or other offshore marketplaces outside the capital control wall, they could move capital back and forth relatively easily between accounts based on their corporate needs. This avenue was shut down. For a while there was also a free financial zone outside of Shenzhen where people could directly move their onshore renminbi deposits offshore. This avenue was also shut down. The most draconian restriction on foreign exchange was to impose a quota on banks limiting how much money they could move out of China on a monthly basis. The most extreme version of this policy stated that banks could only move as much money out of China as they moved into China. Moving more money out of China than you move in is clearly the mechanism of capital reserve depletion. Besides capital control, the other mechanism that has stabilized and strengthened the renminbi was the very aggressive, overseas borrowing by Chinese banks and corporations. A Chinese bank could borrow $100 from a foreign bank, allowing the Chinese bank to move $100 of its clients’ money out of the country. Chinese banks and firms borrowed hundreds of billions of dollars since August 2015 to counteract the capital outflows. These two mechanisms of capital control and massive borrowing have managed to stabilize China’s exchange rate.
. You have referred to these stabilizing measures as quite severe. If stabilizing actions require so much exertion to implement, do you think this rebound is sustainable?
The problem with capital control is that it creates pent up demand for foreign currency exchange and overseas expenditure. It can be sustainable for quite a while, but people will become more and more unhappy with the situation. We have seen cases such as China in the 1980s and North Korea today where countries maintain foreign exchange control for considerable time. China’s weak currency position creates two major problems for foreign exchange regulators. The first is the large amount of trade that China conducts. The trade is in the trillions of dollars, so importers and exporters can exaggerate imports or depress exports slightly to help get money out of China. The other weakness is Hong Kong. Even though Hong Kong is part of China, it sits outside of the Chinese capital control regime. Many individuals or companies can cross that border, sometimes even just by walking across the border with briefcases of cash. This practice continues to sap Chinese foreign exchange reserves. In the short term, the rebound is sustainable. However, in the medium to long term, it is harder to maintain unless they address these loopholes.
What are the effects of the rebound of the renminbi on the Chinese economy?
The renminbi has rebounded, but it was not costless. Many wealthy Chinese still want to get currency out so there are active lobbying efforts to relax this control. The Chinese state bank is also increasing the de facto interest rates in the interbank market. You can slow capital outflows by offering investors a higher return on investments domestically by offering higher interest rates. However, a lot of people also owe money in China, especially corporations. They owe well over 100 percent of GDP in debt and the government owes about 100 percent of GDP. Chinese households are also increasingly indebted, so when interest rates rise, all these entities must make higher payments. This strain has slowed the economy, creating pressure to lower interest rates, which may make the economy better. However, it also re-creates incentives for people to move money out of China, so it’s a double-edged sword.
In reaction to that double-edged sword, would you predict a return to a more market oriented setting of the renminbi? Do you believe this policy will be revived now that the renminbi has stabilized?
The People’s Bank of China recently made a statement that it wants to return to more market-oriented mechanisms to set the exchange rate. But when the Chinese see a lot of outflows, which may be the case now, they often revert to draconian control measures. There will be rhetoric about economic reform and using the market more, but when the Chinese government does not get its desired outcome, it often reverts to heavy administrative control.
The Chinese government has been cracking down on large private companies that have been investing heavily overseas. Will the crackdown ease up now that the renminbi has stabilized? Will the stronger renminbi motivate China’s wealthy people to take advantage of this opportunity to invest their wealth abroad?
The new policies that deter outward foreign investment will continue, but companies will find new ways around it. The latest policy essentially said no more frivolous large-scale investments overseas, like soccer teams, film studios, and property developments. However, if Chinese companies want to make strategic investments in technologies or important sectors, those will likely be approved. Either way, once the capital is offshore, Chinese regulators have little control over where the money goes. Wealthy Chinese and conglomerates will likely package their outward investment as strategic technology acquisition and then funnel the money into other uses. I expect this will happen until the foreign exchange regulators crack down on that kind of practice. Do you think there will become a self-perpetuating cycle such that a stronger renminbi motivates China’s wealthy people to further pursue foreign investment? It depends on what people believe is the future direction of the renminbi. With a stronger renminbi, Chinese investors have greater buying power overseas. If they believe the renminbi will be stable or weaken, it creates a lot of motivation for them to move money overseas. On the other hand, if the Chinese government succeeds in convincing investors that the renminbi will continue to strengthen, the incentives will be weaker. China is not in the position to convince anybody that its currency is going to keep getting stronger. The first reason is because a stronger currency kills exports from China, which is important for keeping a balance of payments. The second reason is because it would require the Central Bank to raise interest rates, something that is challenging to do while the nation is becoming more indebted. China cannot credibly strengthen its currency too much. Rather, it seems that the Central Bank intends to convince people that even though the renminbi will not strengthen continuously, neither will it weaken continuously. The last few months have shown that the bank is capable of strengthening the currency when it chooses to do so. That point has been made clear.
What are the lessons foreign investors should learn from this episode? Many investors thought the renminbi was about to collapse, but they were proven wrong. Do you believe that the market got the Chinese currency wrong when it was betting on its continuous fall not too long ago?
Both on the bearish side and the bullish side, people have learned a lot of lessons. Investors who were bearish, including myself, certainly can no longer underestimate the power and resources of the Chinese government. The Chinese government, more than other governments with wide control over state banks, can draw on immense administrative resources when pursuing on a particular policy goal. Even those people who were bullish on the renminbi have something to learn. Recent events suggest that you can be bullish on the renminbi and China, but the way that China maintains stability on the renminbi is by taking decision-making power out of the hands of investors and placing it under the Chinese government’s control. For instance, if you are an investor buying Chinese bonds, you want to eventually take home your profit from that purchase. The Chinese government has shown through its draconian capital control measures that repatriation of profit is at the discretion of the Chinese governments, and investors have little recourse if their transfers are blocked.
American politicians have often criticized China as a currency manipulator. Do you believe that a strengthening renminbi will help reduce the protectionist pressure on China?
For people in the know and for those who have looked at the data, it is clear that China has maintained an artificially high exchange rate for the last two years, if not longer. In the past, complaints were that the exchange rate was artificially low relative to the dollar in order to export more to the United States. That really isn’t the case anymore, so there are fewer complaints of this sort. Certainly the Treasury Department has refrained consistently from labeling China as a currency manipulator. China has held for many years an internationalization agenda for the renminbi. Yet worldwide transactions don’t typically include the renminbi and the Chinese currency remains a small percentage of foreign held reserves.
What roadblocks still exist for the renminbi as an international currency?
The largest roadblock is capital control. The problem that China saw in 2015 was that after changes to the peg, investors could short the renminbi outside of China. In order to short something you basically borrow it and then hope it crashes in value before you pay back your broker. In order to short a currency, there needs to be liquidity in the form of renminbi circulating outside of China’s capital control regime. Back in 2015 there was that liquidity, primarily in Hong Kong, to the order of 1 trillion renminbi. In response, China drastically limited the pool of renminbi outside the foreign exchange regime. If you look at the Hong Kong data, at some point renminbi deposits fell by 50 percent. Although, being down 500 billion renminbi sounds like a lot, it isn’t relative to the Chinese money supply, which is over 100 trillion renminbi. So long as China will not allow a large pool of renminbi to circulate internationally, it will limit, by definition, the internationalization agenda. This continues to be the case. If there were a large pool of offshore renminbi, China would have to commit to a flexible and truly market-based exchange mechanism, reducing the government control of the currency.
Featured Image by ReeveJ (Own work) [CC BY-SA 3.0 (https://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons