Bad IMF advice for China

In the context of China’s bid for its currency to be included in the IMF’s Special Drawing Right (SDR) basket, the International Monetary Fund (IMF) seems to be dispensing poor policy advice to China with respect to its exchange rate and external capital account management. By pushing the Chinese policymakers to further liberalize their country’s exchange rate and to open up their capital account at this delicate juncture for both the Chinese and the global economies, the IMF risks not only heightening China’s present economic difficulties, but also undermining the global economic outlook.

{mosads}Amid mounting evidence that China’s economy is now slowing and that its outsized credit market bubble is bursting, Chinese residents have been exporting capital abroad at an alarming rate. According to the country’s official international reserve data, over the past year. China experienced capital outflows in excess of $500 billion. Much of that outflow occurred in the third quarter of 2015 in the immediate aftermath of China’s surprise August decision to allow its currency to depreciate by around 2 percent.

Last week, in an effort to stimulate China’s flagging economy, the People’s Bank of China cut interest rates for the sixth time over the past year. By so doing, it further reduced the incentive for Chinese savers to keep money at home, particularly at a time when the Federal Reserve is mulling an interest rate hike and when doubts have arisen as to the stability of the Chinese currency.

Against this background, one has to question the IMF’s pressure on China to move toward a more flexible exchange rate and toward a more open capital account as conditions for the Chinese currency’s inclusion in the SDR. One would think that further downward movement of the currency at this particular juncture would only validate Chinese savers’ fears about the future direction of the currency. One would also think that any further easing in capital account restrictions would only accelerate capital outflows from China as it became easier for Chinese residents to ship capital abroad.

From an international perspective, the IMF’s push for China to have a more market determined exchange rate could not come at a worse time for two basic reasons. The first is that with China presently experiencing massive capital outflows, the move to a market-determined rate without central bank intervention would almost certainly lead to a very sharp depreciation of the Chinese currency. The only thing presently holding up the Chinese currency is the Chinese central bank’s willingness to sell U.S. dollars in large amounts from its international reserve holdings.

The second is that with the global economy now slowing, both the European Central Bank and the Bank of Japan appear poised to step up their already very expansive quantitative easing programs. While for obvious reason they will not publicly own up to it, they will do so in order to cheapen their economies’ currencies for competitive advantage. If China too were now to substantially depreciate its currency, this would all too likely heighten the risk that the world will move to an all-out currency war that could have very harmful effects on the global economy and on world financial markets.

For China’s sake, as well as for that of the global economy, one has to hope that Chinese policymakers disregard the IMF’s policy advice and drop their quest for inclusion of their currency in the SDR basket at any cost. The last thing that either China or the world economy needs right now is instability in the Chinese currency market that could have serious adverse consequences well beyond China’s borders.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.