Chinese yuan - Where do we go from here?

CHINA's yuan has been under pressure due to the trilemma challenge - flexibility of exchange rate, openness of capital account and control over domestic interest rates - which has been building up in China since mid-2014 and has intensified earlier this year.

Against a backdrop of weak productivity trend impacting private corporate capex, slowing wage and weaker export growth, downward pressures on GDP growth has been building up for some time. This, coupled with the persistence of deflationary pressures, has meant that nominal GDP growth in China has slipped to a post-credit crisis low of 6.0 per cent in 4Q15 from an average of 18.5 per cent four years back. This narrowing growth differential relative to the rest of the world (both trailing and expected), falling returns on domestic assets (reflected in rising incremental capital output ratio) and narrowing real interest rates differentials (due to the need for an easy monetary policy stance) with the US, has led to capital outflows and a decline in FX reserves from mid-2014.

The approach to addressing the trilemma pressures evolved in different phases. In the first phase from June 2014 to July 2015, policy makers chose monetary easing (control over interest rates) as the most important policy decision, and ran down FX reserves, which declined by US$342 billion over this time frame. Keeping the currency stable against the US dollar had meant that the yuan had been appreciating on a trade weighted basis.