The exchange rate of the Chinese yuan has been continuously and heatedly debated over the past year. As the yuan exchange rate against the greenback approaches the psychological 7.0 threshold, people have become increasingly focused on whether the yuan's gradual devaluation is sustainable and whether China should allow a free float of the yuan.
In my opinion, the yuan exchange rate should remain pegged to a currency basket rather than free float for three reasons.
First, China's existing yuan exchange rate maneuver model has proven to be sustainable. Since the yuan central parity rate reform on August 11, 2015, the yuan rate has undergone two respective phases of disorderly and orderly movements. During August-December 2015, the yuan devaluation pressure was sharply pushed up by excessively loosened control in the central parity rate of the yuan, which consequently led to resonant behaviors of both a depreciation trend and a depreciation expectation. In 2016, when the yuan exchange rate's peg against a basket of currencies was in place, yuan movements became controllable, with the deduction in China's foreign exchange reserves slowing down to a monthly level less than half of that in July-December 2015. And expectations of yuan depreciation were steady against the strong rally in the dollar.
Second, allowing the yuan rate to free float may not necessarily relieve the pressure of yuan devaluation, but will inevitable carry substantial risks. There is a belief that adopting a free float of the Chinese currency could be a one-off relief of the yuan's depreciation, and that as long as the yuan has depreciated enough, appreciation pressure will eventually emerge. But it should be noted that the exchange rates are not entirely determined by economic fundamentals, and fluctuations in the yuan's exchange rate could threaten to feed directly back into the yuan itself by affecting yuan expectations. Besides, embracing a free float could create excessive yuan devaluation. In this respect, pinning our hope on a one-off depreciation to achieve yuan equilibrium is unrealistic. On the contrary, large volatility would be unavoidable after a free float with financial and economic shocks that are difficult to estimate. Therefore, it wouldn't be wise to have a free-floating yuan.
Third, maintaining stability in the yuan exchange rate is necessary in helping the country filter relevant impacts triggered by excessive volatility in foreign exchange markets. A survey from the Bank for International Settlements has shown that "trading in foreign exchange markets averaged $5.1 trillion per day in April 2016," however, the yearly global output currently was just slightly above $70 trillion. Apparently, speculative activities that are not relevant to the fundamentals represent a considerable portion in the foreign exchange markets' huge trading volume. The Tobin tax, a levy on foreign exchange trading to reduce speculative factors in foreign exchange markets that was proposed by Nobel Prize-winning U.S. economist James Tobin, hasn't been enacted, but the problems Tobin noted have gained momentum. In particular, after the subprime mortgage crisis, extremely loose monetary policies adopted by central banks across the globe prompted huge volatility in the exchange rates of global currencies. Under such a backdrop, steadiness in the yuan can help rule out external speculative attacks against China and maintain domestic economic and financial stability.
China's current yuan exchange rate adjustment model also comes at a cost. People have criticized efforts to stabilize the yuan rate that have drained a large volume of foreign exchange reserves and have negatively noted that relevant authorities have stepped up restrictive measures regarding capital exodus. In addition, depreciation expectations in the forward rates of the yuan are also heating up, showing that enhanced efforts are needed to stabilize the yuan exchange rates. Even though allowing the yuan to free float could avoid the above problems, this move could lead to greater risks and cost at an ever higher price.
Therefore, it is necessary to keep yuan exchange rates under control and speed up policy measures to contain yuan devaluation expectations. After all, China's $3 trillion foreign exchange reserves serve as one of the trump cards of the Chinese government. However, if the country exercises undue caution in making moves and missing out on the right opportunities, those cards will be useless.
In light of U.S. President-elect Donald Trump's proposed loosened fiscal policies, its sovereign debt level will inevitably rise and boost its domestic performance and prop up the dollar. But we need to note that the U.S. interest rate hike will negatively impact the US economy, so the rallying of the dollar is unlikely to be sustainable. The best plan at this point is to strengthen efforts in stabilizing the yuan.
