As it linked domestic money creation solely to FX reserves, China has decided to abandon its decade-old dollar peg to benefit from the flexibility of fiat money1 and avoid adding to the incipient deflation. With the yuan over-valued to the dollar by 25%, the PBoC is caught between a rock and a hard place: (i) risk deflating domestic money aggregates by running down its FX reserves to defend the yuan/dollar parity or (ii) disconnect money creation from FX reserve accumulation. Accord-ingly, a little over a week ago, the PBoC announced it was opting for the latter by introducing open-market operations (OMOs).
The switch to OMOs is a milestone in resolving the monetary consequences of China’s bursting financial bubbles as it is the only way to prevent monetary deflation and modernise monetary policy. Indeed, while it has rightly decided to favour a sterilised stabilisation of the yuan (i.e. using capital controls instead of FX reserves), China must keep money aggregates rising (or risk a balance-sheet recession): the loss of credibility due to the planned switch to fiat money must be compensated for by (i) carving out failed bank assets and (ii) using tradable quality assets in money-market operations.
The PBoC’s switch from a de facto currency board to fiat money is indispensable but risky: success depends on how key factors within and outside the PBoC’s reach are dealt with over the coming year(s). Indeed, the inter-bank money market must be (i) rid of impaired financial assets (i.e. banks must be cleansed of their impaired assets) and (ii) filled with quality tradable assets (for which direct PBoC loans to banks are a transitory substitute). As a result, the direct loans to be extended by the PBoC to banks from now onwards cannot primarily serve the purpose of under-writing unsustainable bank assets.
Accordingly, the government will be a key contributor to the success of the PBoC’s monetary Big Bang since it will have to bear most of the cost of the indispensable restructuring of the financial sector. Indeed, the temptation could be to swap failed bank assets for government bonds that banks could then take to the PBoC in return for cash: this would, of course, amount to monetising bank problems under the cover of indirect quantitative easing. In this respect, the recent opening of China’s bond market to qualified foreign investors as well as the commitment not to resort to quantitative easing is welcome.
Beyond signalling China’s seriousness in its ambition of modernising its economic governance, the switch away from the dollar peg is also a clever way to avoid being trapped in the impossible trinity, whereby monetary policy cannot be independent if the currency’s FX rate is pegged and capital free to flow in and out of the country. The PBoC has lent credibility to this strategic move by (i) reiterating its pledges not to further cut the reserve requirement ratio for banks or resort to quantitative easing, and (ii) tightening de facto capital controls. Now the risks lie essentially in implementation more than design.
1 Fiat money (aka paper money) is money not backed by a commodity of any sort (gold, silver, etc.) but in trust in the central bank.
China’s monetary Big Bang: breaking with the dollar peg to not devalue the yuan
DOISY Nicolas , Strategy and Economic Research at Amundi