Parallels with China’s currency regime and Australia before the AUD float in 1983

Posted on January 12th, 2016

Despite another bad day on the Chinese stock market on Monday, China used its currency fix, jawboning and possibly intervention to calm volatility in the CNY exchange rate.  This provided some calm to global markets.  A statement by a PBoC official discussing CNY policy appealed for calm but also highlighted a more flexible approach to currency management.  Below we look at the parallels with the Australian experience in the late 1970s and early 1980s as it moved from a peg to the USD to a crawling peg guided by its trade-weighted index and market forces, and eventually to a floating regime in 1983.  Financial and capital control deregulation go hand in hand and once started create their own-momentum.  China’s policy actions over recent years have illustrated this self-perpetuating catalytic effect.  China is likely to continue its reform process and experiment with increasing currency flexibility over coming years, even if at times it may appear to take backward steps to cool depreciation pressure and calm its own and global financial markets. While this is a sensible policy to put the economy on a path to longer term stability, in the meantime it is likely to add to global market uncertainty and a weaker growth path for China.


Dialing up the influence of market forces, within reason

Ma Jun, chief economist at the PBoC research bureau said, “The [CNY currency] fixing is determined by factors including the closing price of the previous day and the changes of the currency basket.  Market participants should look at the differences between fixing and closing prices, and changes of the currency basket.”

This is consistent with previous statements from the PBoC that CNY policy will take into consideration both market forces and the trade-weighted index.

Ma implied the fixing each day is related to the difference between the fixing on the previous day and closing prices. This element reflects market forces; if the market pushes USD/CNY higher to above the fix, it indicates selling pressure on the CNY, and it might encourage the PBOC to raise the fixing rate the next day.

Of course, the Chinese authorities can still exert as much control as it wishes under this regime.  It can use intervention to push down the USD/CNY relative to the fix, and thus limit or even reverse the difference between the USD/CNY rate and the fix.  But one might conclude the spirit of this policy is, within reason, to allow the market (supply and demand) to play a bigger role in the direction of the USD/CNY.

Parallels with Australia 1974 to 1983

The currency policy developments in China has much in common with that implemented by Australia in the decade before it eventually freely floated the AUD in December 1983.

Major currencies were floated in 1973 after the collapse of the Bretton Woods System.  Australia persisted with a peg to the USD until September 1974, when it was devalued by 12% and moved to a peg against a basket of currencies.

 In November 1976, the AUD was again perceived to be over-valued and the currency was devalued this time by 17.5% and moved to a crawling peg against the USD.  Under this new regime a small group of officials (the so-called ‘troika’) kept movements of the Trade Weighted Index (TWI) under review, adjusting it via the daily peg against the $US. (Ref: Major Influences on the Australian Dollar Exchange Rate; Blundell-Wignall et al 1993).

The “crawling peg” in Australia from 1976 to 1983 was intended to prevent the build-up of appreciation or depreciation pressures (followed by discrete adjustments).  The value was set daily by a joint decision of the RBA, Treasury and the Department of the Prime Minister and Cabinet. While day-to-day changes in the value of the Australian dollar were initially small and infrequent, they became larger and more frequent over time. For example, in 1977 the value of the trade-weighted index (TWI) peg was adjusted on just 46 trading days, whereas in 1983 the TWI was adjusted on 121 trading days (prior to the eventual float of the currency on 12 December). (Ref: Financial Reform in Australia and China; Ballantyne et al)

This description of the AUD crawling peg is similar to that made by Chinese officials with respect to its regime since it devalued the CNY in August this year.  It is setting a fix for the CNY each day based on its assessment of movement in other currencies and their effect on the CNY trade weighted index, and is assessment of market forces and their effect on the movement in the CNY exchange rate relative to the previous day’s fix.

The aim of the Chinese authorities may be to dampen speculative capital flow and its influence on domestic liquidity and monetary conditions, by allowing the CNY exchange rate to adjust and balance market forces.  By allowing it to adjust it hopes to also avoid making large one-off revaluations again such as the de-val in August last year.

However, this policy may often have the opposite effect and spur on speculative capital flows seeking trading opportunities in the greater currency flexibility.  This may be especially true in the case of China where many players may see the currency’s flexibility as a way to bet on perceived fundamental problems in China associated with excessive debt creation over the last 7 years since the 2008 GFC and restructuring in the economy to a growth model less reliant on heavy industries, construction and export demand.

In maintaining any type of tightly managed currency regime it is essential to have polices that control capital flows and keep them relatively balanced.  In both Australia in the 1970s and China now, capital controls are employed and the banking system is still tightly regulated.

In particular, China still maintains very tight controls on private sector capital outflows.  However, Chinese people and companies have found many avenues to get capital abroad some less legal than others over recent years.  Chinese authorities have eased rules from time-to-time and enforced them with more leniency.  At other times it has stepped up its enforcement and limited these capital outflows to dampen depreciation pressure on the CNY.

It is the stated policy of the China to eventually remove capital controls and allow its currency to float freely.  Allowing more flexibility in the exchange rate is a significant step in this process.  This explains why China has tested the waters by tentatively allowing more capital outflow in recent years.

These capital flows not only directly influence supply and demand for the currency, they also affect domestic liquidity, forcing the authorities to adjust domestic money market policies to avoid unwanted tightening or easing of monetary conditions.

The decision by Australia to adopt a full-float in 1983 arose because as it deregulated its banking system and capital controls the crawling peg was no longer effective in limiting capital flows.  Speculative activity on the exchange rate increased and large capital flows were generating excessive volatility in domestic liquidity. As such, the RBA could no longer effective manage monetary policy.

“On 9 December 1983, faced with the prospect of further large capital inflows, the authorities suspended banks’ foreign currency trading to allow time to decide on a course of action. The decision was made to float the Australian dollar – effective from 12 December 1983. While some brief consideration appears to have been given to the alternative option of strengthening capital controls, such controls were considered costly, ineffective and inefficient (Laker 1988).”

China is not so far down the path that it is likely to abandon its capital controls and float the CNY.  But it does appear to be at the stage where it wants to allow the CNY more flexibility and test how it copes with tentatively allowing more capital freedom.

Dangers faced by moving too fast

An important consideration for China is the much bigger size of its financial sector assets (debt and securities) relative to its GDP and the global financial system than that in Australia in 1983.  Furthermore, the global financial system is now much more integrated.  A sudden deregulation of capital controls would have much greater potential to cause internal and global financial market chaos and real economic fallout.

It is easy to imagine in the current situation that sudden capital outflow might cause a big liquidity crunch on the more stressed property and heavy industry sectors in the Chinese economy that could spread across the Chinese and global economy.

Nevertheless, the current policy stance in China appears to be aimed at making more progress towards currency flexibility, allowing some greater freedom in capital flows, and accelerating somewhat the process of forcing consolidation in industries that have excess capacity and too much debt.

Some controlled weakening in the exchange rate would help the economy via supporting the tradable goods sector and countering deflationary forces.  Limiting its financial support for troubled industries may force them to consolidate faster.  At the same time it is likely to maintain overall easy monetary policy via quantitative monetary policy and lowering reserve requirement ratios of banks to help underpin overall growth to counter the contractionary forces of consolidation in troubled industries.

 It has been using its large stock of FX reserves to smooth out exchange rate volatility while allowing some additional freedom in capital controls and more currency flexibility

Over time, once it has achieved progress in consolidating its troubled sectors, it may have more balanced economic growth, it may be in a better position to remove capital controls, deregulate the banking system and float the currency, in a fashion similar to Australia in 1983.

Catalytic effect

In the research discussion paper by the RBA cited earlier, it concluded that experience in Australia underscores the potential catalytic effects on financial development of a decision to liberalize. In other words, reform creates its own momentum.

China is experiencing the need to accelerate its reform process to keep up with feedback on its financial system and capital flows generated by its initial steps to deregulate and wind-back capital controls.  Its recent actions on the exchange rate and increased resolve to deal with troubled sectors reflect an urgency to stay ahead of this feedback.

For China it will take considerable political resolve to continue this progress.  It may be tempting to reverse course, but that may cause much bigger problems for the economy in the medium term if it doesn’t deal with excesses in the economy.  The time already appears to be running out to address these problems.

Unfortunately, the benefits of deregulation, as the RBA paper notes, “may only be felt once the system has adapted to changed arrangements and the credibility of the post-reform policy framework and institutions have been established.”

The RBA paper also concluded that the path to reform is not without risks and the stakes are undoubtedly higher for China (and the world) that they were for Australia in the early-1980s.

Heightened risks to global markets

From an immediate global markets perspective policy actions in China generate higher risks now for global markets; they point to tighter credit conditions in troubled sectors in China that are likely to weaken economic growth and commodity prices.

They point to a weaker CNY and diminishing Chinese FX reserves, which is likely to place some upward pressure on US yields and the USD and cause some disruption in global capital markets as it adjusts to less Chinese government and sovereign wealth fund support for alternative reserve currencies and global bond markets.

While Chinese private sector capital flows may provide some support for global asset markets, this may not be enough to compensate for more conservative investment attitudes of global investors, observing the changing pattern of capital flows from China and greater economic uncertainty.