The recent depreciation in the value of China’s currency is the result of the slowing pace of its economic growth, and events outside its borders such as the Federal Reserve’s tapering of its asset purchase program, the People’s Bank of China Deputy Governor Yi Gang said Thursday.
Speaking at an event on the sidelines of the IMF/World Bank spring meetings, he said his expectation is for the renminbi’s flexibility to increase, with up and down movements in its value becoming the norm.
Gang also said his order of priority as China works to loosen state control over its economy is first exchange rate flexibility, followed by liberalizing interest rates, and then capital account mobility.
U.S. Treasury Secretary Jack Lew Wednesday voiced concerns about the recent depreciation in the value of China’s currency, but Gang argued that looking at the movements of the renminbi’s exchange rate in February and March, “you’ll see we are facing the international, external environment of QE tapering by the Fed.”
The currency is also facing downward pressure from the data signals predicting a slowdown in China’s economic growth, he continued.
“So if you look at what (Fed Chair) Janet Yellen’s saying, and the trade figures in China, and also economic indicators,” Gang said, if the market believes the renminbi should be heading in the direction that it is now, “then I think that we should let it go.”
Still, he said it is “perfectly normal and understandable” that the U.S. is concerned about the recent yuan depreciation, but assured that the worries will be alleviated.
“I believe that as time passes by, people will see clearly and better that the entire exchange rate regime mechanism in China is moving towards a market-oriented model,” he said.
Gang said the volatility being experienced by the renminbi is minor compared to other emerging market currencies such as the Brazilian real.
He downplayed the recent movements of China’s currency, noting it has only depreciated by around 2%. Compared to the the euro or yen, “that kind of movement is perfectly normal,” Gang said.
“My forecast is that in the future, the renminbi will – more or less – see its flexibility increase, and it will float in both ways,” he said.
Gang stressed that unlike in the past, when the value of the currency only appreciated, “in the future… a two-way fluctuation could be a normal situation.”
The ongoing overhaul of China’s financial sector was the main topic of the event, and Gang said officials are facing some difficulty in carrying out financial reform, holding up interest rate reform as an example.
He noted that interest rate controls with regards to the bond market and bank lending have already been eased, but what is still lacking is interest rate control on the deposit side.
The government is facing at least two difficulties, Gang said.
The first issue is that the so-called “micro foundation” is not ready yet, he said, as many companies, and especially some local government finance vehicles, do not have strict budget constraints.
The absence of such constraints means such entities tend to borrow without accounting for what the future costs or impact might be, Gang said.
“If you don’t have the micro foundations, this means that corporations, firms and government finance vehicles will not respond to interest rate signals – even very high interest rates,” he said.
“Which means we are not ready for interest rate liberalization yet,” he added.
There is also an issue on the macro level, Gang continued, noting that right now China is facing “a little bit” downward pressure on the economy.
With growth in the first quarter likely to be slower than expected, “if you liberalize interest rates at this point, you know the rate is going to go up – at least for the short term.”
This would increase the cost of capital, Gang said, meaning more negative news for the economy.
Given these concerns, Gang said the reform push should continue, especially making the exchange rate more flexible.
Also, “you can do some cautious step-by-step interest rate liberalization,” he said, while also engaging in a larger scale capital account convertibility.
This cannot be done overnight, he cautioned, particular in light of China’s current exchange rate regime.
Opening the capital account while a fixed exchange rate is in place would be risky, he said, without the mechanism to manage inflows and outflows – as happened in Thailand during the 1997 Asia crisis.
Gang noted there remains a “carry trade” or arbitrage activity between the U.S. dollar and renminbi. “If you don’t manage that well, you also create some fluctuations in terms of capital flows.”
He made clear, however, the government will press on with reforms efforts because “a very high proportion of Chinese people will benefit.”