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The PBOC's Exchange Rate Dilemma

By Frances Coppola

Back in 2015, the People's Bank of China (PBOC) abruptly devalued China's currency, the yuan. At the time, this was widely regarded as a prelude to floating the yuan's exchange rate. But two years on, the yuan is still not floating.

Chinese authorities have chosen instead to support the yuan's exchange rate by means of exchange rate and capital controls. However, China is under international pressure to liberalize its financial regime and open up its economy to foreign trade and investment.1 The question therefore remains – will China float the yuan, and what might that mean for international businesses affected by China's system of capital controls?


How the PBOC's Mandate Affects the Yuan's Exchange Rate


The decision whether to float the yuan is complicated by the PBOC's legal mandate. The "Law of the People's Republic of China on the People's Bank of China" says that the aim of monetary policy is "to maintain the stability of the value of the currency and thereby promote economic growth."2


This is a somewhat ambiguous mandate. The "value of the currency" could be interpreted as meaning the domestic purchasing power of the yuan, which would make this a single "price stability" mandate like that of the European Central Bank (ECB) or the Bank of Japan (BoJ). But it could also be interpreted as meaning the external value of the currency, namely the exchange rate. This seems to be how the PBOC has interpreted it, historically. Certainly, the PBOC has never adopted an inflation target, as other central banks have done. Rather, it maintains the exchange rate of the yuan within a narrow band against the exchange rates of a basket of currencies.


Managing the exchange rate in this manner has financial consequences for China. To prevent the yuan's exchange rate from falling, the PBOC has to sell down foreign currency reserves: in November 2016, as the U.S. dollar's exchange rate soared, the PBOC's foreign currency reserves fell to a six-year low.3


Resolving the "Trilemma": Floating Exchange Rate or Capital Controls


Maintaining the yuan's exchange rate parity can also mean restricting the activities of foreign businesses. The famous "trilemma" says that a country cannot combine independent monetary policy with a fixed or managed exchange rate and free movement of capital. Thus far, China has maintained independent monetary policy by restricting the free movement of capital rather than floating the yuan's exchange rate. For international businesses, this can make investing in China and repatriating profits from China complex and difficult.


However, there are signs that the PBOC wants to change this regime. In an interview with the Chinese magazine Caijing, the central bank's Governor, Zhou Xiaochuang, identified what he termed a "troika" of reforms to liberalize the Chinese financial sector. These include a more market-based exchange rate mechanism in which the yuan can be allowed to find its own balance, relaxation of capital controls so that the yuan can be more widely used internationally, and more foreign trade and investment.4


Governor Zhou sees the eventual floating of the yuan as an essential stage in the opening up of China's economy to the outside world. He explains that a more liberal foreign exchange mechanism and looser capital controls are two sides of the same coin: "Reducing foreign exchange control, and improving the degree of exchange of capital projects, is actually the same thing. Like the chemical PH value: acidity means lower alkaline, alkaline means less acidity. Similarly, reducing foreign exchange controls means an increase in the degree of currency convertibility; an increase in the convertibility of capital projects means a reduction in foreign exchange controls." And he goes on to explain that liberalizing capital flows, thus opening up the Chinese economy to more foreign trade and investment, requires moving to a real market equilibrium exchange rate for the yuan.5


However, he emphasizes that the transition to a floating exchange rate needs to be gradual to avoid shocks that can be highly disruptive to business. "In the absence of open conditions, the vast majority of the time the exchange rate is in an unreasonable, uneven level. To this end, foreign exchange management departments need to control the use of foreign exchange," he says.6


Moving to a Floating Exchange Rate for the Yuan


So, when will the PBOC float the yuan and relax capital controls, as Governor Zhou recommends? At present, it is not clear. Governor Zhou is scheduled to retire at the end of 2017, so the decision may be made by his successor. Much depends on the view of the Chinese government regarding the pace and timing of China's migration to developed-country status. However, Governor Zhou seems to regard the inclusion of the yuan in the International Monetary Fund's SDR basket as setting China on an inexorable path towards the eventual ending of capital controls and adoption of a fully floating exchange rate regime.7



Currently, doing business with China can be challenging, due to the system of capital controls that restrict movements of money in and out of the country. However, there are signs that the PBOC wants to relax capital controls and move to a floating exchange rate regime for the yuan. If this is the case, then eventually businesses may find that doing business with China becomes easier as capital controls are relaxed, although they may need to focus more attention on managing foreign exchange risks arising from a floating yuan exchange rate.

Frances Coppola - The Author

The Author

Frances Coppola

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. “China needs to come clean on its exchange rate policy,” Financial Times;
2. “Law of the People’s Republic of China on the People’s Bank of China,”;
3. “China November forex reserves fall more than expected to lowest in nearly six years,” Reuters;
4. “SDR: the historical process of the opening to the outside world,” Caijing (in Mandarin);
5. Ibid.
6. Ibid.
7. Ibid.

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