Q&A on Trade Disputes And the Renminbi

Sino-US relations have been strained by a bitter trade dispute. How has this affected China's balance of payments situation and what might be China's response? Will there be an impact on foreign exchange policies or the internationalization of the renminbi? To answer these questions, China Forex interviewed Mu Zhiqian, a former consultant to the State Administration of Foreign Exchange. The discussion follows in question and answer form.

Q: The Sino-US trade dispute was a key issue in 2018. What impact has it had on China's balance of payments? Have financial authorities felt much pressure from this?

A : An impact of the Sino-US dispute on China's balance of payments was unavoidable. The question has been how much of an impact would there be? Similarly, financial authorities have been tested by the dispute. How much pressure and how authorities respond are the key issues.

In 2018 China saw a shift from higher inflows of foreign exchange to a basic equilibrium in the balance of payments.The trend has three key features.

First, the two-way flow of foreign exchange has finally reached a relative balance after a period of intense inflows and then a gradual easing of inflows.

Second, the data on foreign exchange services of banks showed narrowed deficits in receipts and payments as well as settlements and sales of foreign exchange.

Third, the deficit in forward settlements and sales of foreign exchange declined. At times there were surpluses.

These features reflect the general trend in China's balance of payments over the year. Specifically, the inflows on the current account and capital inflows from foreign investment grew at a rate of 6% or more, basically in line with China's economic growth rate. It can therefore be said that the impact of the Sino-US dispute on the balance of payments over the year was tolerable.

Q: Does this modest impact actually reflect tighter controls on movements of foreign exchange? It seems that enterprises, especially foreign-funded ones, have been reporting a considerable degree of inconvenience in moving funds out of China. They contend that procedures are unnecessarily complicated. For example, they note that there are requests for details on the purpose of remittances as well as requirements of support documentation such as contracts and invoices.

A : The degree of regulatory oversight changes as circumstances change.For instance, China became a more attractive destination for hot money after the global financial crisis in 2008. At that time, foreign exchange regulators focused on stemming inflows of short-term speculative capital. In the second half of 2015 there were heavy outflows of capital and China's regulators shifted their focus to halting capital flight. To a certain extent it can be said that foreign exchange regulation changes with the shift in exchange flows.

The reach of the nation's regulators is long. The priorities are large sums of money or sums that involve questionable sources.Whether or not this degree of regulation is required for all transactions is another matter. Nevertheless, the principle that fund movements should be based on real underlying transactions must be observed.

Q: China is promoting the use of renminbi in overseas direct investment (ODI) in countries covered by the "Belt and Road" initiative (a major program for boosting trade and infrastructure development). Does that mean China wants the renminbi to replace the use of US dollars and euros in order to ease downward pressure on the nation's foreign exchange reserves?

A : This issue is not that complicated. In fact, most of the investment along the "Belt and Road" program is in infrastructure construction. Over the course of construction on these projects there will be many related transactions between China and the investment destination. Using renminbi for these investments is more convenient. Why use other currencies when there is a more convenient one at hand?

Of course, using renminbi for outbound investment related to the Belt and Road initiative will mean there is also less of a reduction in our foreign exchange reserves as well. At the same time, using the renminbi for investments will promote the international role of our currency.

Q: The reference to foreign exchange reserves brings us to a sensitive question. Is the US$3 trillion level of foreign exchange reserves a red line that cannot be crossed? Is this the level of reserves required to cushion any impact from a worsening of the Sino-US trade dispute or other emergencies?

A : Three trillion dollars is a static point in a dynamic process. It is not reasonable to set a particular number because this changes according to conditions, particularly in light of the unpredictable Sino-US dispute.

How will China deal with potential risks stemming from this dispute? As an old Chinese saying goes, it is wise to live within your means. That applies to good years and bad years. I believe China will be able to adjust to all circumstances.

Q: It seems that whenever the renminbi slides towards the level of seven yuan to one US dollar, it starts to reverse course. Seven seems to be a magic number. Does this reflect intervention from China's central bank? Can the renminbi exchange rate be kept at this level?Are macroeconomic regulators worried about the renminbi's depreciation to more than seven yuan to one US dollar?

A : Forecasts on this matter differ. Some analysts say the level of seven yuan to the dollar will be breached sooner or

later. That is unavoidable. Others say that the exchange rate of renminbi must be kept on the strong side of that level.

In fact, the renminbi's exchange rate has remained in relative equilibrium. While the Emerging Market Currency Index (EMCI)underwent a sharp slump of 10%, the renminbi currency basket index on the China Foreign Exchange Trade System (CFETS) declined by only 2.6%. The mid-rate of the renminbi against the US dollar showed a cumulative decline of 5%. Whether the rate will hold to the strong side of seven to the dollar mainly depends on the stability of China's economy and developments in the Sino-US trade dispute. In other words, it is up to the market to decide.

Regular, direct intervention in the foreign exchange market by the central bank has already been halted. The regulatory focus has shifted to managing market expectations. What's more important than holding the line at seven yuan to the dollar is to work for greater flexibility in the exchange rate and maintaining stability.

Q: Many foreigners find China's financial policies difficultto understand. In a few words, can you explain the key features of the renminbi exchange rate regime for us?

A : The existing exchange rate regime for the renminbi allows gradual depreciations and appreciations. This system of exchange rate adjustments is referred to as a crawling peg. In this system a currency is allowed to fluctuate within a designated band. The value of the currency and the band may be adjusted frequently, particularly in times of high volatility. In regard to the renminbi, its mid-rate is mainly determined by two factors. One is supply and demand on the domestic and international foreign exchange markets.The other is a basket of international currencies, which is composed of 24 key currencies that are closely related to China's foreign trade. The US dollar carries the most weight in this basket, followed by the euro.

When necessary, China's central bank will introduce the use of a counter-cyclical factor to keep the yuan's daily midrate at a relatively stable level. The counter-cyclical adjustment factor was first introduced in May 2017 as a third factor in addition to the basket of trade-weighted currencies and the renminbi's closing spot level compared with the previous trading day's level when setting the official mid-rate. The objective in using this additional factor was to help keep the renminbi stable at a reasonable and balanced level.

Q: What are your expectations for China's balance of payments in 2019? Do you expect a loosening of foreign exchange regulation or a tightening?

A : Personally, I expect a basic equilibrium in the balance of payments. That means a steady inflow of foreign exchange as well as steady outflows. That means no big deficit or surplus in the balance of payments.Yet in real life there are many uncertainties,especially when there are numerous external factors that are beyond our control.

In regard to foreign exchange regulation, I think we will see both easing and tightening.For the areas of the market that have already been opened or will be opened further,regulation will be eased and self-discipline of market participants or industry in general will play a greater role. At the same time, preventive measures will be taken against speculative activity related to foreign exchange.

The views of Mr. Mu are his own and do not necessarily reflect SAFE policy.