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Will market volatility stall China's liberalisation plan?

Financial market turmoil has dominated economic news from China over the last month but has the volatility stalled the crucial move towards freer financial markets? BlueNotes put the key questions to ANZ China economist Li-Gang Liu and head of global financial markets research Richard Yetsenga

BlueNotes: The volatility we have seen has raised concerns from international observers and investors around the ability of China's government to stabilise its unpredictable stock market and manage its currency policy. Do you think those concerns are warranted?

"Domestic reforms are likely to take policy focus over some of the currency and financial sector issues which have dominated (from the external perspective) the reform agenda for a number of years."
Richard Yetsenga, Global Head of Financial Markets Research

Richard Yetsenga: The continued instability in the domestic economy and financial markets is putting China's policy framework under some pressure. That is certainly true. A tightly managed exchange rate appears to have become progressively inconsistent with both the economic setup in China and the broad-based liberalisation of cross-border flows.

At the same time, a genuinely flexible exchange rate seems to be inconsistent with near-term financial stability – both in China and in the region. More forceful intervention has become necessary to preserve stability in the currency. This necessitates even more meaningful domestic easing because of the impact of the reserve drawdown on domestic liquidity.

Volatility has placed new pressures on Chinese financial market policy

  • Medium term trend remains a more market driven RMB  although large devaluations will be acted against
  • IMF reserve currency decision gives China more flexibility  with RMB
  • Longer term policy challenge remains capital account liberalisation
  • Domestic considerations may delay pace of reform but  not stop it

But then the easing, over time, is likely to add to depreciation pressure on the currency. Individual policy moves may not add all that much depreciation pressure but certainly the risk is in that direction, particularly if a sequence of moves which cumulate to an aggressive policy response becomes more widely expected. The cost of rebalancing these forces may be some further financial market instability over the period ahead.

We shouldn't forget, however, that a flexible currency is an important part of China's shift towards operating a modern economy, financial system, and exchange rate. That ultimate goal is an important, and beneficial, medium-term objective.

BN: Was it a surprise then when the International Monetary Fund signaled the Yuan won't be added to its basket of reserve currencies for at least a year? Were you surprised by this outcome?

Li-Gang Liu: The move by the IMF to delay changing the composition of the SDR basket is hardly surprising. This is all but a technical delay to avoid changing the SDR basket at the end of the calendar year and to allow more time for IMF members to adjust to the new basket - if the RMB does make it to the basket.

The decision is still going to be made in November. In fact, by keeping the current basket composition until September 2016, the IMF may be giving Beijing more time to push forward with reforms in order to meet the requirements set forth by the IMF.

BN: Are there any other actions China's policy makers can take to continue to lobby for the currency's inclusion?

Liu: The bone of contention for this year's review is to determine whether the RMB is a 'freely usable currency' in trade and financial transactions. The recent move by China to change the RMB fixing regime is a good start, as a more market-based exchange rate would facilitate RMB's inclusion into the SDR.

However, going forward, the authorities will have to continue with reforms to accelerate capital account liberalisation. Programs such as launching the Shenzhen-Hong Kong Stock Connect, Qualified Domestic Individual Investor (QDII2), and further pilot programs in free trade zones can facilitate the opening of China's capital account.

BN: One of the most significant moments in the recent turmoil was the decision to devalue the yuan. Did markets respond the way you might anticipated? And how has that played out in other markets?

Yetsenga: Currency depreciation from the world's largest exporter, while only modest at this stage, has generated substantial concern. Initially the response was most felt in Asian currency markets. Asian economies were already experiencing the weakest global trading conditions in several decades, as well as continued pressure on domestic demand as the unfolding tightening in USD liquidity ahead of the US Federal Reserve's first hike permeates through domestic financial systems. That initial response being confined largely to Asia, however, has since broadened to encompass global financial markets. Equities have been particularly volatile.

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BN: So what can we expect to see from China in the next financial year? Do you expect the country's policy decisions to continue to drive volatility?

Liu: It will be important for the People's Bank of China to manage the market's expectations after the devaluation earlier this year.

Managing a floating exchange rate system will be a steep learning curve for the central bank and it will continue to be tested by some unexpected future domestic and external events.

That said we believe that it is not in China's interest to allow large exchange rate volatilities. The central bank has recently rejected market speculations for a sharp depreciation of the exchange rate by 10 per cent.

Given the large foreign debt exposures by Chinese corporates, a large depreciation may significantly increase the debt burden of these firms. In addition, excess exchange rate volatility may hurt the RMB's chances to enter into the SDR basket.

BN: What then is the long-term road map now for the RMB? Has the plan for financial market liberalisation changed?

Yetsenga: China's intent to liberalise both its financial markets and currency is unlikely to change, although certainly the exact path and the timing could shift as a result of China's current circumstances.

Over much of the post-crisis period, China has had a relatively stable domestic backdrop against which to reform its domestic financial system and financial markets, cross border capital account and exchange rate. At present, however, efforts to stabilise the domestic environment could see cyclical considerations take precedence, at least for a time, against some of the other reform efforts.

This is not to suggest that reform is stalling, far from it. It is more that domestic reforms are likely to take policy focus over some of the currency and financial sector issues which have dominated (from the external perspective) the reform agenda for a number of years.

BN: The over-riding anxiety outside China is the danger policies won't work as expected. If China succumbed to an economic hard-landing, would liberalisation be impacted?

Liu: Given the current environment, slower growth may be inevitable though we do not believe an economic hard-landing scenario will materialise given huge policy leeway and good fiscal fundamentals.

China will still be one of the fastest growing major economies of the world, even if growth were to slow to 5-6 per cent in the coming years.

Slowing economic growth will not impede China's reforms and financial market liberalisation. In fact, some important financial liberalisation remains firmly on China's agenda over the medium to long-term: developing a vibrant bond market, liberalising interest rates and capital account liberalisation to name a few.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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