South China Morning Post, 11 March 2014,

  
The yuan's exchange rate is far from being the result of a carefully considered policy. 


Analysts have built entire careers analysing and re-analysing China and its economy. They make predictions, get proven wrong and move on to the next topic. It's been a very profitable pursuit given that the so-called facts in much of the analysis are often completely divorced from reality.

China's exchange rate policy is a case in point. In the past decade, Beijing has been widely criticised for maintaining an exchange rate policy that severely undervalues the yuan. It is also universally agreed that that policy results from China’s mercantilist culture. 

It is said that the reversal of the yuan's exchange rate in the past two weeks was an official attempt to punish speculators and stop a one-way bet on the yuan. The mandarins in Beijing are portrayed as having a carefully thought-out and meticulously executed strategy on exchange rates.

They don't. And here's why. The yuan's exchange rate – whether it is undervalued or overvalued – is the result of policy inaction, which is the government's habit of just muddling through. 

The mandarins in Beijing work with whatever they happen to have and try very hard to maintain the status quo, whatever the consequences of that status quo. Whatever the exchange rate happens to be, the Chinese officials tend to try to keep it where it is, even when it is very undervalued or very overvalued. 

Suppose, when we wake up tomorrow, that the yuan is suddenly half its present value against the US dollar. Will the supposedly mercantilist Chinese government officials be happy? 

No! They will see that rate as being too good and too favourable to the Chinese! They do not want something like that. They will want the old rate of six yuan to the dollar. But if the yuan slowly moves towards five to the dollar, then five will become the appropriate rate as far as the Chinese government is concerned. This odd state of affairs is a consequence of a series of historical accidents. 

Those busy overanalysing the supposed shifts in Chinese exchange rate policy do not understand this history. In the few decades until the early 2000s, China maintained an overvalued yuan. When I started to work for the People's Bank of China in 1983, the yuan was officially fixed at two to the dollar, while the rate in the vast black market was between seven and eight yuan to the dollar. 

By the time I left the central bank six years later, the prevailing black market rate had surged to 15 yuan to the dollar. The government had been determined to keep the yuan’s official rate extremely overvalued, against the advice of the International Monetary Fund, the World Bank and others. As a regulatory officer, I had participated in the central bank's work that began with monitoring and then clamping down on the black market. A large number of officials and black marketeers were punished and even put behind bars for violation of foreign exchange controls. 

But the black market got bigger each year. So big, in fact, that the government had to introduce coupons to ration the limited amount of foreign exchange reserves. This was not officially abandoned for 16 years. Partly to minimise corruption, the Chinese government devalued the yuan sharply, by as much as 30 per cent in one stroke, to 8.5 yuan to the dollar in 1991. That move, coupled with several other factors, significantly boosted China's exports and reduced the scope for black marketeers over the next two decades. 

The problem is that the devaluation was overdone, and the growth of the country's foreign exchange reserves has got out of hand. Policymakers in the real world have political, social, and economic imperatives to deal with. Sometimes, they make policy based on gut instinct. 

Today's analysts forget the consensus view on China's exchange rate from the 1980s to the early 2000s. Back then the yuan was considered overvalued and set for imminent demise. 

I was a contrarian voice in the 1990s when, as an analyst at HSBC, I declared that the yuan was undervalued and that China did not need to sell a dollar-denominated bond that HSBC and Goldman Sachs were underwriting. I began working for UBS soon after. 

So what is the lesson to be drawn from analysing China’s foreign exchange movements over the last 35 years? First, it is wrong to conclude that China has a natural bias towards an undervalued yuan. Second, it is pointless to read too much into the supposed Chinese exchange rate policy. 

When I was at the central bank, I never felt that there was a policy on the exchange rate, except to keep the status quo. Analysts may say that some policies are “unsustainable”, but they can be stretched for many more years – even for decades. Just because an exchange rate severely deviates from the “fair rate” does not mean it will correct in the near term – not least because the definition of fair value is a fudge anyway.

 Joe Zhang is the author of Inside China’s Shadow Banking: The Next Subprime Crisis?