Guest Contribution: “Misinterpreting Chinese Government Intervention in Financial Markets”

Today we are fortunate to have a guest contribution written by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at Harvard University, and former Member of the Council of Economic Advisers, 1997-99. A shorter version of this column appeared at Project Syndicate.

It is tempting to view economic events in China through a single template: the view that they are driven by government intervention because the authorities haven’t learned to let the market operate. After all, Mao’s portrait still hangs on the wall and the Communist Party still governs. But the lens of government intervention has led foreign observers to misinterpret some of the most important developments this year in the foreign exchange market and the stock market. An instance of such misinterpretations is the confused positions of many American congressmen which have helped bring about the opposite of what they really want from China’s exchange rate.

To be sure, Chinese authorities do often intervene strongly in various ways. In the foreign exchange market, the People’s Bank of China intervened heavily during the decade 2004-13, buying trillions of dollars in foreign exchange reserves and thus preventing the yuan from appreciating as much as it would have if it had floated freely. Hence years of US allegations of currency manipulation. More recently, in the stock market, the authorities have deployed every piece of artillery they could think of in a vain attempt to moderate the plunge that began in June of this year.

But some important episodes that foreigners decry as the result of government intervention are in fact the opposite. Two developments this year have dominated the financial pages, but have often been misinterpreted. Exhibit A is the depreciation of the yuan against the dollar on August 11. Exhibit B is the bubble in the Chinese stock market that led up to the June peak.

China in August gave American politicians an instance of the adage, “Be careful what you wish for, because you might get it.” The widely decried 3% “devaluation” of the yuan was the result of a change by the People’s Bank of China in the arrangement for setting the exchange rate, a change that constituted a step in the direction of letting the market decide. This is what US congressmen have long claimed they wanted and, even now, confusedly still claim they want.

The change sounds technical, but is easily described. China’s central bank has for some time allowed the value of the yuan to fluctuate each day within a two per cent band, but has not routinely allowed the movements to cumulate from one day to the next. The change on August 11 was to allow the day’s depreciation to carry over fully to the next day. Thus market forces can play a greater role in determining the exchange rate.

It is probable that China would not have chosen this time to give the market a larger role in setting the exchange rate if market forces were not working in a direction, toward depreciation, that would help counteract this year’s weakening of economic growth. [And, peering within the country’s decision-making process, it is likely that China’s political leaders were primarily motivated by the desire to support the weakening economy while the People’s Bank of China was primarily motivated by its longer-term reform objectives.]

But these two motivations are consistent: market forces would not be pushing so clearly in the direction of currency depreciation if it did not correspond to the fundamentals of the economy. Market determination of exchange rates can indeed serve a useful function, even if the American politicians who demanded that China float did not realize what the result would be. In any case, if what they really wanted was something different, one can hardly blame the authorities for taking them at their word.
It is said that a year is a long time in politics. A year should have been enough time for American politicians to figure out that market forces had reversed direction in mid-2014 and that an end to Chinese intervention in the foreign exchange market would now depreciate the currency rather than appreciate it.

To be sure, China is far from a free-floating currency, let alone from full convertibility of the yuan. Convertibility would require further liberalization of controls on financial inflows and outflows. Unification of onshore and offshore markets, not floating of the currency, is what would be required for the yuan to merit an IMF decision this year to include the currency in the definition of its SDR (Special Drawing Right). Much commentary ahead of the IMF decision underestimated the importance of the criterion that the currency must be “freely usable.” Increased flexibility alone was not going to be enough to do the trick.

In truth, a 3 percent change in the exchange rate – the size of the so-called “devaluation” against the dollar – is negligible. For example the euro and Japan’s yen have each depreciated far more than this over the last year, against both the dollar and the yuan.

China’s adjustment is said to have triggered a “currency war” of devaluations, relative to the dollar, among a number of emerging market countries. Most of this was due to happen anyway. It has been at least a year since the economic fundamentals shifted against emerging markets (and especially away from commodities) and toward the US. It is natural for exchange rates to adjust to the new equilibrium. The Chinese move likely influenced the timing. But the currency war framework is misleading.

What about China’s stock market? The commentary says not only that the authorities consistently pursued a variety of artificial measures to try to boost the market on the way down but also that they did the same during the huge run-up in stock prices between mid-2014 and mid-2015. The allegation is that the Chinese authorities, particularly the stock market regulator, have not learned how to let the market operate and that they had only themselves to blame for the bubble in the first place.

There is some truth to this overall story. There was some simple-minded cheer-leading of the bull market in government-sponsored news media, for example.

But many commentators have failed to notice that the regulatory authority, the China Securities Regulatory Commission, took steps to try to dampen the last six months of market run-up. It tightened margin requirements in January 2015. It did it again in April. At that time it also facilitated short-selling, by expanding the number of stocks that could be sold short. And the event which apparently in the end “pricked” the bubble was the June 12 announcement by the CSRC of plans to limit the amount brokerages could lend for stock trading.

The adjustments in margin requirements are the sort of counter-cyclical macro prudential regulatory policy that we economists often call for, but less often see in practice among advanced economies. Perhaps surprisingly, it is more common in Asia and other emerging markets. A recent study, for example, found that China and many other developing countries adjust bank reserve requirements counter-cyclically. Another found effective use of ceilings on loan-to-income ratios to lean against excessive housing credit.

Yes, the extraordinary run-up in stock market prices from June 2014 to June 2015, when the Shanghai stock exchange composite index more than doubled, was fueled by an excessive increase in margin borrowing. Reasons for the increase in margin borrowing include its original legalization in 2010-11; easing of monetary policy by the People’s Bank of China since November 2014 in response to slowing growth and inflation; and the eagerness of an increasing number of Chinese to take advantage of the ability to buy stocks on credit.

Nevertheless, the stock market regulator responded by leaning against the wind. Similarly, when the People’s Bank of China has intervened in the foreign exchange market over the last year, it has been to dampen the depreciation of the yuan, not to add to it. These are not trivial points.

This post written by Jeffrey Frankel.

14 thoughts on “Guest Contribution: “Misinterpreting Chinese Government Intervention in Financial Markets”

  1. Ricardo

    So we have two lakes connected by a channel. One is called China Lake and the other America Lake. Those living on American Lake decide they want to use more water so they draw from the lake. After being measured it is found that China Lake water level has fallen. But the American Lake is considered by the legal authorities as the standard lake and so they accuse those around China Lake of manipulating their water level to maintain its level to that of the American Lake.

    Now those surrounding American Lake accelerate their water removal until China Lake, being a shallower lake, begins to have dry spots. Those surrounding China Lake drop a large well and begin to pump water into their lake to maintain its level and use. Once again the authorities accuse the China Lake residents of manipulating their water level and demand that the China Lake residents allow “the market” to determine the water level because obviously the China Lake residents are not allowing the market to work.

    Moral: There is no market when currencies float; all monetary authorities of necessity constantly manipulate their currencies. Neither is there a standard other than that created by the authorities by fiat.

  2. Steven Kopits

    With respect to exchange rates, Jeffrey, there were two mistakes, in my opinion.

    First, political leadership mistook a strong dollar for a weak yuan. Back around January, I would bet that you will find a PBOC analysis from technical staff stating that the US dollar was appreciating, most likely due to the impact of shale oil production on the US current account. As a result, US trading partners were in effect devaluing against the dollar Further, this document will have argued that, should China maintain a dollar peg rather than devalue along with other US trading partners, China’s exporters would lose market share not only in the US, but across virtually the entire global economy, and therefore the yuan should be devalued roughly along the lines of China’s nearest competitors, say, the Koreans.

    This report was rejected by senior political leadership, and therefore a dollar peg was maintained, eventually producing exactly those results of which the earlier PBOC analysis had warned.

    Faced with facts on the ground, senior leadership decided to permit a devaluation, thereby correcting an earlier policy mistake.

    Now, the question was the size of the devaluation. As you point out, 3% is not enough. It probably had to be on the order of 10%. But someone, now maybe the PBOC itself, opted for a gradualist approach of a percent here and there over time. Nothing wrong with that in principle.

    Unfortunately, this approach unleashed an end-of-days reaction from global markets, and of course, both the PBOC and senior leadership are now gun-shy of any further devaluation. Failure to quickly and fully devalue the yuan was the second policy mistake (although it seemed prudent at the time).

    So China policy is now, it seems to me, caught between two chairs. The yuan is still over-valued, but the Chinese are scared to devalue further.

    I personally believe China has to finish the devaluation. Whatever the number is, and no matter the global reaction, finish the devaluation and reset the yuan to a competitive level. Failing to do that will just prolong the agony and risks deepening any recession.

    What do you think?

    1. Ricardo

      “I personally believe China has to finish the devaluation. Whatever the number is…”


      That is the problem. With floating world currencies no one knows what the number is. It changes from moment to moment with our electronic FOREX markets and the manipulations of Central Banks around the world. Whether there is a currency war going on or not CBs are constantly trying to guess “whatever the number is” and trying to change their currency so they gain an advantage or at least keep others from gaining an advantage at their expense. The amount of resources wasted on this totally manufactured problem is mind-boggling.

      1. Steven Kopits

        Yeah, OK. But the yuan was nailed to the dollar from April until this latest devaluation. Look at the first graph in the article, the Index graph.

        I think this tells us a few things. First, you can see the PBOC abandons a creeping revaluation against the dollar in December. Then there’s a little devaluation and some drift, a bit down. And then there’s a small yuan revaluation in late March, and effectively a dollar peg since then. What does this tell me? First, it suggests that the PBOC thought the incumbent exchange policy was no longer working in December. And then there was some indecision, and some willingness to let the yuan slip. Events seem to have culminated in late March, when perhaps the PBOC staff was looking for more latitude to devalue the yuan. But then there was a little revaluation and a lock-in. That lock in, it feels like the technocrats lost a battle right there. “Let’s end this devaluation talk. Just peg the yuan to the dollar and be done with it.” And someone saluted, said, “Yes, sir,” and muttered under his breath, “Well, they’ll learn the hard way.”

        Ever been an analyst in a big organization? If you have, then you know that conversation.

          1. Ricardo

            Good article! My conclusion is in a slightly different direction. As in the past, US deflation sends shock waves around the world that cannot be avoided with devaluation by other currencies. Other countries just have to ride the wave until it passes.

        1. Ricardo

          Steven Kopits wrote:

          “Ever been an analyst in a big organization? If you have, then you know that conversation.”

          Yes and Yes!

          Pegging to the dollar has proven to be destructive since FDR confiscated all the gold and then “stole ” (per Democrat Senator Gore) from the citizens. Then Nixon cut the rope to the anchor and the monetary authorities have been a floundering ever since.

          1. Ricardo


            Deflation is a monetary event not a fiscal event. The US dollar has been appreciating since late 2011. Granted it had been seriously debased under Bush/Obama prior to that but the dollar has now appreciated where the price is below its 10 year average. Because most of the world supplies raw materials to the industrialized world an appreciating dollar does serious damage to their export revenue. Yes, the US does have some bright spots and is actually seeing some benefit from lower commodity prices but this has a devastating impact on the countries exporting those commodities. So yes, there is deflation in the US being passed on to the rest of the world.

            The world needs a booming US economy so that it begins importing once again, but if the FED continues to allow the dollar to appreciate the world is going to suffer with a sluggish US recovery.

            The restrictionary forces of the demand theory economists are very strong. I just saw a main stream projection of 2% as a normal growth rate. That is the the growth rate that made the UK slip to a second class economy in the late 19th early 20th Century. Just consider the ridicule presidential candidates receive when they say we are capable of 4% growth. There was a time when 4% growth was not all that surprising. Consider the growth rate of the Reagan recovery, or for that matter of the 19th Century before the alchemy of QE. The economists who gave economics the name “the dismal science” are still panicking over an overheated economy even though we are still in the doldrums.

          2. Steven Kopits


            I don’t think your analysis is right.

            If the dollar appreciates, and a commodity in denominated in dollars (as is oil), then an non-US exporter will see revenues rise in local currency terms. If I am an exporter, I want to see my currency weak, because it improves my competitiveness, and I get more money in local currency terms.

            Commodity prices have indeed collapsed, in part due to a weak China, which accounts for typically 50-100% of demand commodity growth, when indirect consumers (eg, Brazilians and Indonesians) are included. Further, the supply side has caught up to the demand side, and in fact, we are seeing over-supply in a number of commodity sectors. But that is only related to dollar strength to the extent that US commodity production–notably shale oil production–is increasing supply, displacing oil imports to the US, and reducing oil prices globally.

            So a weak China and strong commodity supply growth are depressing commodity prices–true. But a strong dollar is helpful to exporters, except those who peg their currency to the dollar, notably China.

            As for the US in the doldrums, the JOLTS survey and initial unemployment claims strongly refute this notion. Productivity and GDP growth may be subpar, principally for reasons to do with demographics, but that does not mean the US economy is not strong, in the sense of providing jobs for most people who want to work. An economy can overheat even in the absence of productivity gains, it seems to me. The JOLTS survey tells us, at least with respect to labor, we are beginning to approach the limits of gains from simple re-employment of the otherwise unemployed.

            Indeed, the JOLTS data tells us that those who want to work now are largely employed. The numbers of those who do not want to work may have increased, due to demographic aging, changing gender expectations, desire to study, or because government policy makes it possible to avoid working for a living. To bring this latter group back into the market, we must either reduce the incentive not to work (ie, restrict disability and welfare); reduce the disincentive to work (ie, lower income tax rates); or increase the incentive to work (ie, higher wages). From a market perspective, we’re talking higher wages.

            Now, are higher wages inflationary? I don’t know. Maybe not. But I think most economists consider large wage gains to typically be associated with higher inflation.

            In any event, I think we can consider the economy to be more ‘normal’, and I think we can begin to contemplate interest rates more commonly associated with a normal economy.

            Thanks for the note on NPR, by the way. I think I have been on NPR’s Marketplace four of the last five or six weeks, and on CNBC twice in the same period. Ironically, I can’t think of a stretch where I’ve given worse advice to my clients.

  3. Mike

    The Shanghai Stock Exchange and the value of the yuan get the media attention, but the key to China’s issue is a balance of payments problem that many economists don’t perceive. Over the past year, China has had capital outflows on the order of $500 billion. Some outflows ($350 billion per Goldman Sachs) have been to slow the decline of the yuan. But the remainder is old fashioned capital flight by “smart money” – executed much of the time via devious means. The small adjustment to the yuan (2-3%) may stimulate the economy a little in the very short term, but the decline in reserves has the opposite effect of tightening monetary policy, which will restrain their economy on a longer time horizon. This is China’s economic dilemma – driven by internal political forces.

    Other countries with large balance of payments problems have ultimately devalued their currency with double digit moves – sometimes large double digit declines. The Chinese government did not act soon enough to stem the decline of their international competitiveness. They may stumble about with more small adjustments, but eventually they will announce a sharp decline in the value of the yuan. This will cause some significant banking problems.

    1. Ricardo


      If the whole world devalues would the whole world increase exports?

      If Europe sees its exports increase and its imports decrease and most of their imports are from assembly work done in China, how do you expect the balance of payments to react in China? If China devalues its currency will that stimulate Europe to increase imports?

    2. Mike

      Today, Bloomberg said that as of 31 July, 2015, China has had capital outflows on the order of $600 billion during the prior 12 months. Also, the chief economist at Citicorp said China is “financially out of control”.

      The issues are much bigger than stock market regulation and 2% tweaking of the exchange rate, as suggested in the above article. When the large currency devaluation occurs in the yuan, deflationary price pressures will be felt worldwide because of China’s large import / export relations with major economies. We will also see some banking difficulties, but it is very hard to know where and how large that impact will be.

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