By Frances Coppola
There have been some famous examples of the trilemma in action: the U.K.’s disorderly exit from the European Exchange Rate Mechanism in 1992 is one such example, as is the U.S.’s suspension of dollar-gold convertibility in 1971. In both cases, regaining control of monetary policy involved floating the currency exchange rate. Monetary policy in many countries has now come to mean managing interest rates to control domestic inflation, while allowing currency exchange rates to respond to global market conditions.
But China is taking a different approach. It prefers to manage its currency exchange rate by using capital and exchange controls.
In August 2015, after months of selling U.S. dollar reserves to maintain the yuan’s USD exchange rate peg, the People’s Bank of China (PBOC) abruptly devalued the “onshore” yuan (CNY) versus the dollar. Analysts wondered whether the PBOC’s move heralded eventual floating of the CNY.
Nearly two years on, it seems clear that floating the CNY is not the PBOC’s intention. Rather, it is attempting to manage the trilemma using a combination of capital and exchange controls with periodic revaluations of the CNY’s exchange rate versus a basket of currencies.
The devaluation in August 2015 brought the official value of the CNY close to that of the “offshore” yuan (CNH) traded through Hong Kong, which is set by market forces. This eliminated the possibility of a carry trade between CNH and CNY. It also enabled the PBOC to say that the CNY’s exchange rate responds to market forces, a key requirement for its inclusion in the International Monetary Fund’s elite Special Drawing Right (SDR) basket of currencies, alongside the U.S. dollar, euro, yen and British pound.1 There have been several more CNY devaluations since, all aimed at keeping the onshore and offshore exchange rates close together.
During 2016, the CNY-USD exchange rate fell by over 6 percent,2 largely due to the rising U.S. dollar as the Federal Reserve started to raise interest rates. A large devaluation was widely expected early in 2017, but did not happen.3 But analysts think that if the Federal Reserve continues to raise interest rates, capital will flow from China to the U.S., putting downwards pressure on the CNY’s dollar exchange rate.4 The “trilemma” says that if China wishes to avoid draining its U.S. dollar reserves, the PBOC must either eliminate the exchange rate difference by raising interest rates and/or devaluing the yuan, or it must tighten capital controls. Currently, it mostly seems to be choosing the latter.
Towards the end of 2016, as the yuan’s exchange rate slid, Chinese authorities imposed a range of new capital controls designed to prevent wealthy Chinese individuals and corporations moving money out of China. The measures included restrictions on Chinese investment in foreign companies and overseas real estate.5 Controls already in place included scrutiny of cross-border payments to clamp down on over-invoicing, instructions to banks to ensure that incoming and outgoing payments balance, strict limits on mainland Chinese purchases of Hong Kong insurance policies, and restrictions on so-called “junket trips” to Macau, whose casinos have become a popular way of moving money out of mainland China.6 There was also a clampdown on individuals smuggling cash notes out of China.7 In May 2017, in a further attempt to clamp down on capital flight via its casinos, Macau imposed limits on cash withdrawals from ATMs by mainland Chinese residents.8
As a result of the capital controls, capital flows out of China slowed and the CNY’s exchange rate strengthened in the first part of 2017.9 But even with capital controls, China has not managed to maintain fully independent monetary policy. In March 2017, the PBOC raised domestic interest rates in response to the Federal Reserve’s decision to increase the Federal Funds rate.10
The most immediate effect of China’s new capital controls was to dampen business investment. As the principal aim of the capital controls was to reduce outflows, they mostly affected Chinese businesses and households. But overseas acquisitions by Chinese companies fell by 64 percent in the first quarter of 2017.11
However, there is concern that tighter exchange controls and restrictions on cross-border payments may make it difficult for foreign businesses operating in mainland China to pay suppliers or repatriate funds.12 China has now started to loosen its capital controls,13 but for businesses the possibility of renewed capital controls in the future creates an uncertain trading environment.
China’s recent capital controls have principally affected domestic Chinese businesses and households, rather than foreign businesses. However, foreign businesses may face uncertainty in future if the Chinese authorities continue to use capital and exchange controls as a principal means of managing the yuan’s exchange rate.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1."IMF Launches New SDR Basket Including Chinese Renminbi, Determines New Currency Amounts", International Monetary Fund; https://www.imf.org/en/News/Articles/2016/09/30/AM16-PR16440-IMF-Launches-New-SDR-Basket-Including-Chinese-Renminbi
2.“USDCNY (5-year tab)”,Bloomberg; https://www.bloomberg.com/quote/USDCNY:CUR
3.“Is devaluation of the yuan affecting China’s market performance?”, Market Realist; http://marketrealist.com/2017/03/devaluation-yuan-affecting-chinas-market-performance/
5.“Why China is cracking down on outbound deals”, Financial Times; https://www.ft.com/content/3238c656-b6ac-11e6-ba85-95d1533d9a62
6.“Beijing battles to close capital flight loopholes”, Financial Times; https://www.ft.com/content/1249fb38-b613-11e6-ba85-95d1533d9a62
7.“China cracks down on ‘financial ants’ smuggling cash to Hong Kong”, Financial Times; https://www.ft.com/content/6aa1faca-bd2e-11e6-8b45-b8b81dd5d080
8.“Macau proposes new ATM curbs to tackle Chinese capital flight”, Financial Times; https://www.ft.com/content/2809e6e0-33c2-11e7-99bd-13beb0903fa3
9.“China’s yuan outflows plummet, showing capital controls pay off”, Bloomberg; https://www.bloomberg.com/news/articles/2017-01-20/china-s-yuan-outflows-plummet-showing-capital-controls-pay-off
10.“China raises money market rates after Fed move”, Financial Times; https://www.ft.com/content/4d008f42-0a0c-11e7-97d1-5e720a26771b
11.“China’s tough capital controls put the brakes on outbound deals”, South China Morning Post; http://www.scmp.com/business/global-economy/article/2085109/chinas-tough-capital-controls-put-brakes-outbound-deals
12.“China’s capital controls dent inbound investment”, Financial Times; https://www.ft.com/content/07392a72-241b-11e7-a34a-538b4cb30025
13.“China lifts renminbi capital controls as outflows pressure eases”, Financial Times; https://www.ft.com/content/519b02cc-24e6-11e7-8691-d5f7e0cd0a16