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China should take advantage of its current exchange rate strength and favourable interest rate differentials to further liberalise its capital account, granting more access to foreign investors seeking yuan-denominated assets and making it easier for Chinese companies to expand investment abroad, a former senior PBOC official told MNI.
But Sheng Songcheng, former director of the People's Bank of China's statistics department, said in an interview that the central bank should not be tempted to do away with foreign exchange tools such as its counter-cyclical factor and Foreign Currency Risk Reserve Deposits, which would help it to confront excessive exchange rate volatility if necessary.
With production and consumption still recovering from the Covid-19 shock, the PBOC is likely to further lower policy rates to guide down the loan prime rate, which serves as a benchmark for corporate loans, Sheng said, although it will emphasise its flexibility and will be careful not to undermine the yuan. Heavily indebted regional governments need low rates to cope with falls in fiscal revenue, he noted.
For now, China's relatively rapid economic recovery has reduced incentives for funds to flow out of the country, and easing capital controls would benefit Chinese companies seeking to carry out foreign direct investment. This would promote increased international use of the yuan, and could mitigate the effects of deteriorating economic relations with the U.S., Sheng said.
Chinese companies could find investment opportunities in the countries of Beijing's One Belt One Road project, with their often favourable demographics, and elsewhere as their international competitors struggle with the economic impact of the global pandemic, according to the 20-year PBOC veteran.
Overseas direct investment by Chinese non-financial companies totaled USD80.2 billion in the first half of the year, 34% lower compared with the same period of 2019, Ministry of Commerce data shows. This continued a steep decline since a 2016 peak, with 2019's total USD97.7 billion down 32% from 2018. Non-financial companies' investment in the U.S. plummeted to USD4.8 billion in 2019 from USD46.5 billion in 2016.
While part of the reason for this shift has been U.S. restrictions on Chinese investment, much of it was also due to tightened capital controls following the depreciation of the yuan in 2015, when authorities overhauled the quotation mechanism for the yuan's central parity rate of yuan against U.S. dollar, Sheng explained. The minimum level for overseas payments requiring approval by the State Administration of Foreign Exchange was also lowered to USD5 million from the previous USD50 million in November 2016.
China should welcome foreign direct investment, Sheng said, but noted that it should also remain vigilant against short-term speculative inflows as it opens up, particularly as ultra-easy global monetary policy triggers a search for yield among international investors.
The PBOC has multiple tools should these risks materialise, he said. Possible responses could include the imposition of an unremunerated reserve requirement along the lines of similar rules in Iceland. Taxes on financial flows could also be enacted.
While the authorities would in the longer term like to see a stable yuan, slightly stronger against the dollar, its rally of recent months, with both the onshore USDCNY rate and the offshore USDCNH strengthening beyond 6.85 to the dollar on Aug. 31, could potentially lure more hot money into China, as well as reduce exporters' competitiveness, Sheng said. Even though the yuan's strength against the dollar has been partially balanced by some depreciation against the euro, the CFETS Weekly RMB Index, which tracks a basket of the currencies of 24 of China's major trading partners, has increased for six weeks in a row, reaching 93.52 last Friday.
Some policy advisors expect the PBOC to use this period of yuan strength to accelerate market-oriented reform of its rate formation mechanism, but Sheng disagreed. While the PBOC has retreated from regular intervention, and has barely used the counter-cyclical factor in determining CNY daily fixing over the past year, it should keep these tools in reserve, he argued. A rise or fall of 2% from the official midpoint rate the PBOC sets each morning is a wide enough band for spot trading, he said.
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