Reducing risks in yuan trading

For emerging economies, the fragility of their financial system and their fully floating exchange rate mechanisms have increased the possibility for the outbreak of financial risks, as indicated by interrelations between the Asian financial crisis and the region's financial liberalization. Under the push of the Washington Consensus and the International Monetary Fund, the world experienced a peak in capital account liberalization in the 1980s and 90s. In this context, developing countries represented by Southeast Asian and Latin American countries spared no efforts to introduce foreign capital to boost their economic development. However, the failure to set up a capital regulation firewall and lax management of capital outflows resulted in the eruption of the crisis, especially in countries with a high foreign debt ratio, a large current account deficit and insufficient foreign reserves.

The Impossible Trinity theory says that a country or region cannot realize an independent monetary policy, a free capital flow and a stable exchange rate at the same time, and that the realization of any two targets must be based on the abandoning of the one remaining. The large-volume international capital inflows and outflows truly comply with the principle of the free flow of capital, but they will have direct impacts on a country's exchange rate and monetary market.

Short-term speculative capital and its arbitrage activities on the yuan in recent years have brought huge risks to China. To avoid a precipitous fall in asset prices and a possible capital exodus, the country's monetary authorities should tighten management of the yuan's exchange rate in the onshore and offshore markets, keep a close watch on the chain reaction caused by the yuan's depreciations, and, if necessary, put in place a Tobin tax and strengthen the early warning mechanism for capital flows.

China should also strengthen international financial cooperation to deal with a new round of risks. It should also deepen financial cooperation with regional members to jointly deal with the effects brought by the US' QE withdrawal and changes in the global financial pattern, and accelerate the building of the Chiang Mai Initiative, multilateralization and other agreements aimed at promoting Asian financial stability. At the same time, a self-managed common foreign reserve fund should be set up with regional countries to accelerate building a regional financial safety network to maintain financial stability of China and Asia.

The author is an associate research fellow with the China Center for International Economic Exchanges.