China prepares for a US tapering

The administrator of China’s State Administration of Foreign Exchange, Pan Gongsheng, who also serves as deputy governor of China’s central bank, says that China is well prepared for a US tapering.

The US Federal Reserve has signaled that it will soon taper, or gradually reduce, asset purchases. There is an expectation that, when this happens, US bond yields will rise, thereby stimulating flows of capital from other countries into the United States. That, in turn, would likely put upward pressure on the value of the US dollar, or downward pressure on other currencies, especially those in emerging markets. Indeed, bond yields and the US dollar have already risen recently, partly in anticipation of the shift in policy.

In China, policy makers have lately publicly addressed this issue. China is in a favorable position compared to many other emerging countries, given its vast supply of foreign currency reserves. Moreover, it has regulatory limit s on outflows of capital, although investors in China are often able to find ways to move money in and out of the country. This includes using false valuations for invoices of either imports or exports.

Still, once the US Federal Reserve starts to act, China will face a choice. It can either continue to stabilize its exchange rate, which would likely entail selling foreign currency reserves—doing so would mean a tightening of Chinese monetary policy as it would entail a reduction in the central bank’s volume of assets—or it could let the currency float, in which case it might depreciate sharply. This would boost the competitiveness of exports, but it would also add to inflationary pressure. Moreover, depreciation might cause further tension with the United States that often complains that China intentionally undervalues its currency. In addition, depreciation would not be helpful to Chinese companies with foreign currency debts. Thus, there is no easy solution.

The administrator of China’s State Administration of Foreign Exchange, Pan Gongsheng, who also serves as deputy governor of China’s central bank, says that China is well prepared for a US tapering. He said, “We have accumulated a lot of experience and policy tools and have taken many pre-emptive actions this year.” Perhaps the experience to which he alludes was related to the so-called “taper tantrum” a decade ago. At that time, markets reacted badly when then Fed Chair Bernanke said that tapering was coming. This time around, there was no tantrum when Fed Chair Powell signaled a change in policy. Still, investors and central bankers are likely experiencing heightened anxiety, nonetheless.

Meanwhile, Pan provided an indication as to how China will handle US tapering. He said that “the yuan exchange rate will be basically stable at a level of equilibrium. As its flexibility improves, it can play a better role in self-adjustment.” In other words, it appears that China intends to let the renminbi float rather than intervene to stabilize the currency. Thus, China would opt to avoid a tightening of monetary policy. The authorities are likely not worried about the inflationary effect of depreciation given that, so far, inflation has remained relatively muted.

Moreover, Pan said, “In the current round of policy tightening, the gap between the US and other economies is apparently smaller in terms of growth and monetary policy. This will affect the room of US dollar appreciation.” In other words, he anticipates that the downward pressure on the renminbi will not be substantial. Moreover, given that the renminbi appreciated considerably in the first year of the pandemic, there is likely room for depreciation without too much disruption to the economy. Finally, keep in mind that predicting currency movements is a fool’s errand. Even after tapering, it is possible that the US dollar may not appreciate, especially if there are other factors that put downward pressure on the dollar, such as higher-than-expected inflation or a delay in normalizing interest rates. Thus, China seems to be prepared for any eventuality.