The People's Bank of Red china (PBOC) faces a dilemma. After near a decade of trying to curb expectations of connected currency appreciation (spurred by People's republic of china'due south current- and upper-case letter-account surpluses), information technology finally succeeded in the commencement quarter of 2014, when its forceful market place intervention drove downwards the renminbi'southward substitution charge per unit to discourage carry trades. Now, even so, the PBOC is facing an even more difficult claiming, as seemingly irreversible depreciation expectations undermine economic stability at a moment when Red china can to the lowest degree afford boosted uncertainty.

Because the 2014 intervention coincided with the weakening of Communist china'southward economical fundamentals, it ultimately amounted to pushing on an opening door. Instead of providing credible resistance to upwards pressure on the exchange rate, as intended, it triggered an outright reversal, with depreciation expectations beginning to creep into foreign-exchange markets.

Thus, in the second quarter of 2014, China recorded a capital-account deficit for the first time in decades. And by the first quarter of 2015, that deficit more than start the current-business relationship surplus, significant that China registered its showtime international balance-of-payments arrears in recent retentiveness.

Still, given the size of Cathay'due south foreign-substitution reserves, markets remained confident that the PBOC could fix the renminbi exchange rate at whatever level it wanted, regardless of China'due south external balance-of-payments position. As a event, depreciation expectations were not potent.

Then, last August, the PBOC lowered the renminbi fundamental parity rate past ane.9%, peradventure in response to an Imf written report encouraging China to align the parity rate more closely with the market rate. The move roiled markets and intensified depreciation expectations. The PBOC rapidly intervened to avert a panic by halting the depreciation, just it was as well belatedly: expectations of further renminbi weakening became firmly established in the market.

Equally these expectations drive an increasing amount of capital out of Mainland china, thereby intensifying depreciation pressure, the PBOC continues to arbitrate in the strange-commutation marketplace, ofttimes in unpredictable ways (in order to discourage speculation). As a issue, the PBOC has de facto adopted a crawling-peg exchange-rate regime.

While a itch-peg system can eliminate brusk-term depreciation expectations, thereby reducing the associated capital outflows, it cannot eliminate depreciation expectations in the more than distant hereafter, let solitary reduce capital outflows unrelated to depreciation expectations. In fact, the itch peg encourages some kinds of capital letter outflows, such every bit carry trade unwinding, the dollarization of household accounts, and withdrawal by portfolio investors. Meanwhile, China'south economical fundamentals continue to worsen.

All of this has forced the PBOC to spend a huge amount of Communist china's foreign-substitution reserves – more than $500 billion in 2015 alone – to go on the level of renminbi depreciation vis-à-vis the U.s. dollar inside 5%. At this charge per unit, those difficult-earned foreign-substitution reserves will soon exist exhausted. That is not an option.

Recognizing the challenge at manus, the PBOC has been allowing the renminbi to fall, slowly just surely, since November. But while this "stealth devaluation" worked for a while, market participants decided at the starting time of this year to dump their renminbi again.

The PBOC at present has three options: it tin stop all interventions and let the renminbi float; link information technology to a basket of currencies; or peg it tightly to the United states dollar, equally it did during the Asian financial crisis of 1997. And so far, however, the PBOC has offered no indication of its plans, beyond the continuation of its current renminbi-sustaining policy.

In my opinion, the PBOC should reinforce the Chinese government's market-oriented reform plans and allow the renminbi to bladder. China is yet running a big current-account surplus and a long-term capital-account surplus, and it has not fully liberalized its capital account; and then the chances are good that the renminbi would non fall likewise far or for as well long.

Moreover, fifty-fifty if the renminbi did experience a double-digit depreciation, Cathay would not exist thrust into financial crunch. After all, the country'southward stock of corporate external debt is not too large; the currency mismatch within Chinese banks is minor; and aggrandizement is just higher up ane%. To bolster such financial buffers, China must enforce existing capital controls much more strictly.

Withal, in that location remains the possibility of a marketplace panic, with all of the dubiousness that such an episode implies. Given this, the PBOC could engineer a transition during which the renminbi is pegged to a basket of currencies, with an adjustable key parity rate and a wide fluctuation band of 7.five% or fifty-fifty fifteen%. It could cull non to announce the (very wide) fluctuation band, so that investors, judging that the renminbi had fallen far plenty, might begin to purchase the currency before it really reached the floor, thereby stabilizing the exchange charge per unit before the PBOC was forced to spend more foreign-commutation reserves.

This yr will be some other hard one for Cathay. But the situation is far from dire. With the right policy mix, Red china should exist able to stabilize its currency and foreign-reserve position, and return to a sustainable growth path.