Central bank imposes new capital controls to staunch outflows

During the last week in August, the People’s Bank of China drew the attention of traders worldwide by cutting the benchmark lending rate 0.25 percentage point to 4.6%.

When the debt-fueled rally turned into a rout for China’s 90 million individual investors, the government moved to stop the bleeding, putting its credibility on the line. As far as significance is concerned, we tend to agree that it may be as relevant.

Nixon’s move involved throwing in the towel “after much gold had left U.S. vaults”.

The reason why the Nixon comparison is valid, nonetheless, is because it may well also be historically just as significant.

This, in turn, will make yuan-denominated assets less attractive to investors, leading to lower foreign investments and possibly capital outflows.

There was always a risk, however, that Beijing would eventually decide that instead of running down foreign currency reserves to support the yuan, it would be easier to severely restrict capital outflows. However, the International Monetary Fund has said that China would need to liberalize its currency before such a step could take place. They make predictions of all kinds – and are often wrong. The West’s economic collapse in 2008 meant that this model could no longer function, and China began trying to grow consumption levels so that the domestic consumer might come to fill the hole left by the faded worldwide market. Inflation has remained stubbornly far below its 2 percent target, exports in July were down from the year before, and growth has been highly unreliable, with second-quarter GDP shrinking at an annualized rate of 1.6 percent. In the past, the central bank would allow CNY to deviate from the fix, until earlier this month, by up to 2%. If this threshold was reached, central bankers would intervene or move the fixed rate closer to the market price. Last week I asked a firm (who wishes to deal abroad) if they had bank accounts set up in overseas markets. They were previously betting on some time around May.

It is a testament to the severity of the downward growth trajectory that has prompted the central bank to undertake this historic change in exchange rate policy. “Once speculators realized the PBoC is in no mood to fight, a two-way market appears to have been established, meaning the currency has had both up and down days since”, the currecy expert explained.

The new reserve requirement comes as China pushes to add the yuan to the IMF’s reserve-currency basket in a review later this year.

The country may not want to embrace an entirely free-floating currency quite yet, given restrictions on cross-border capital flows. In our analysis, an easing of capital controls is the logical next step.

However, China’s equity market still does not possess quality institutional investors like other reserve-currency holders. We expect these markets to be developed much further and to start to converge more as the offshore CNH moves towards becoming one with the onshore CNY.

Led by Chinese currency Yuan, the majority of Asian currencies turned weaker in the global foreign exchange markets. The currency happened to have weakened in the immediate aftermath. China’s intervention in the stock market may be compared to Tulip Mania in the Netherlands, an episode for the history books.

Well, what does it mean for the Chinese currency and the global economy?

China undoubtedly has a huge economy that will eventually become the world’s largest, due to its enormous population.

“All said and done, you may not like the Chinese, but the economy is well connected with all major economies in the world”. This enabled China augment its trade surplus with India by 27.1% from the same year-ago period.

“Companies in these sectors need to be watchful of the overall signals emanating from the Chinese economy, which seem to indicate that a bubble effect exists there on asset prices and any deflation of this bubble would result in erosion of wealth, and hence weak demand for products or pricing pressures for products sold to China”, he says.

But that creates other challenges for Asia’s largest economy.

A clerk counts renimnbi and US dollar banknotes at a bank in Shandong province, August 12.

“With the yuan’s trading expected to be more volatile in the future because of increased uncertainty of the Chinese economy, the PBOC is taking precautions”.