To reform or not to reform: That is the question in China these days. The country is weighing a key decision over whether to simply loosen restrictions on its highly controlled capital account, or to make the yuan, also known as the renminbi (RMB), or “people’s money,” a fully convertible international currency.

Beijing’s dilemma over whether to accelerate the slow evolution toward full convertibility sharpened in August when the government devalued the yuan by almost 2%, catching the markets by surprise. That move unleashed a spate of turbulence that has yet to fully subside, and the most recent bout of acute volatility has accentuated concerns over China’s economic slowdown and its global repercussions. The confusion and anxiety are compounding as capital flows out of China, straining Beijing’s capacity to control the yuan’s value.

The 1.5% drop in the yuan’s value against the U.S. dollar in early January, to its lowest level in five years, reinforced suspicions that China might be opting to devalue the yuan — long overvalued in many economists’ estimation — to breathe some life into its export sector. Economists say Beijing has been failing to communicate its intentions effectively to investors and markets in the wake of the People’s Bank of China’s (PBOC) decision to cut its daily reference rate by 1.9%, triggering the yuan’s biggest one-day drop since China ended its dual currency system in January 1994. The PBOC China called the change a one-time adjustment and said it would better align the yuan with supply and demand.

Seeking to calm the markets and stem capital outflows that have picked up in recent months, on December 11, the PBOC issued a notice that the yuan’s value should be viewed in terms of a trade-weighted basket of currencies rather than just the dollar. That has in fact been the policy for years. However, that step just convinced investors and markets that the central bank was trying to weaken the yuan against the U.S. dollar and other currencies. China’s foreign exchange reserves dropped by a record $108 billion in December and declined by $99.5 billion in January.

Whatever the markets’ perceptions, what China did twice was to move toward greater exchange rate flexibility in keeping with its goal of making the yuan an international currency, says Louis Kuijs, head of Asia Economics at Oxford Economics. “What happened in August and December were moves by the PBOC to relinquish that link with the U.S. dollar and to make the first step toward eventual exchange rate flexibility. The first step that was recommended by many experts was to focus on the basket of currencies instead of focusing on the U.S. dollar,” Kuijs says. “They have tried to focus everybody’s attention more on the basket and keep on telling the market that we have move to focus on the basket rather than the bilateral link with the dollar.”

Opaqueness vs. Transparency

Much of the problem stems from a lack of transparency that is typical of China’s policymaking, since in reality the PBOC did not say explicitly that those were its motives and that in turn damaged its credibility at a time when investors were already worried about the possibility China might devalue.

“They are saying that we are not targeting this or that and they are saying there is no reason the RMB depreciates significantly against the basket,” Kuijs says. Since Chinese leaders have continued to claim they have no intention of weakening the yuan while taking steps that lead directly to that outcome, the market is “not buying or not completely believing what the policymakers are saying.”

The market is “not buying or not completely believing what the policymakers are saying.”–Louis Kuijs

Pieter Bottelier, an adjunct professor of China studies at Johns Hopkins School of Advanced International Studies (SAIS) in Washington, D.C., agrees. “They did not communicate with the market what was the background to, and the intention of, the August 11 policy and the December 11 valuation change,” Bottelier says. “There is a serious problem with the way they explained this to investors, especially to international markets they have been poor in communicating their objectives and intentions.” Bottelier views the intention of seeking stability of the yuan against the trade-weighted basket as an “essentially right policy change, but it was poorly explained.”

So far, those policy shifts appear to have backfired: Expectations of a weakening yuan led to bigger capital outflows as investors shifted their money elsewhere in hopes of protecting their returns, and capital outflows further weaken the currency, a trend that is spreading into other emerging markets. “Recent days saw a large depreciation against the U.S. dollar of all Asian exchange rates except the Japanese yen, with the [South Korean] won down 2% and the Malaysian ringit and New Zealand dollar down almost 3%, and the Australian dollar more than 3%,” Kuijs said in a report issued January 7. Brazil’s real and the Russian ruble also weakened more than 1%.

Economists and forex specialists say the further weakening of the yuan against the dollar would trigger further weakening of emerging market currencies, including weakening of other Asian currencies that could lead to a possible currency war. The Japanese yen is less affected because of the Bank of Japan’s latest monetary easing and the newly effective negative interest rate has not so far led to depreciation. Though the Bank of Japan may intervene or carry out additional easing, many economists are forecasting that the yen might strengthen rather than fall, regardless of the yuan’s movements against the dollar.

Alvin Tan, forex strategist of Societe Generale Cross Asset Research, wrote in a February 1 report titled, “Strategies for a CNY 7.5 World,” which compiles comments by more than 20 Societe Generale analysts and economists, that if the yen-dollar rate drops to 110 yen under the risk scenario of a 7.5 yuan rate to the dollar, a 14% weakening of the yuan, Japanese policymakers may intervene. So the Japanese yen’s rate is likely to be limited to 110 yen against the dollar.

In the same report, Jason Daw, head of Asian forex strategy at Societe Generale Cross Asset Research, wrote that under the risk scenario target of 7.5 yuan, a 14% increase in the U.S. dollar against the yuan would cause Asian currencies to weaken between 6% to 16%: the Korean won by 16%; the Malaysian ringit by 16%; the Indonesian rupiah by 15%; and the Indian rupee by 14%.

Role of the IMF

More generally for China, the irony is that another motivation behind China’s policy change in August was to have the yuan included in the International Monetary Fund’s SDR (special drawing rights) currency basket. SDRs are an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves, but the SDR basket does not play as important a role today as it did in the past when the Bretton Woods system was in place. The yuan’s inclusion in the basket means that the IMF believes that China’s currency has a global standing on a par with the other four currencies in the basket — the U.S. dollar, the euro, the pound and the yen.

The IMF did finally decide in late November to include the yuan in the SDR basket as an international currency. The recognition of the yuan as a reserve currency reflects its growing importance in world trade, but is mainly of symbolic importance, says Rajiv Biswas, a Singapore-based Asia-Pacific economist at IHS Economics. Given the amount of pain suffered as a result of the recognition, “I do not think it was a good idea,” Biswas says. “Trying so hard to get into the SDR basket has just a limited meaning, and it created quite a storm in the currency market and weakened the yuan more.”

In December, China’s voting rights in the IMF rose to 6% from 3.8%, an increase of nearly 60%, after the U.S. Senate adopted reforms giving emerging economies a greater say in how the U.S.-dominated international lender is managed. “That plus the yuan’s new SDR status have created a policy bind for Beijing, because having promised to make the yuan a more international currency and to move toward more flexible exchange rates, China should not intervene heavily in the market,” says Kazuo Yukawa, a professor and contemporary China expert at Asia University in Tokyo. “China should not have rushed to get the renminbi into the SDR basket and should have taken more time,” he says.

More Yuan Weakness Likely

The yuan will likely weaken further this year, despite China’s reluctance to see it fall too fast. Beijing will defend the currency, but the question is how much and for how long. China’s foreign reserves fell by $512.66 billion to US$3.33 trillion by the end of 2015, the first annual drop since 1992, according to PBOC figures.

Some experts worry that flight of private capital may be politically driven by President Xi Jinping’s ramped-up anti-corruption drive.

Notes Biswas: “The real issue is how long they are prepared to defend the yuan, spending reserves every month. It looks like the yuan could go down more. If you think that the yuan will go down more, and you are foreign exchange trader, you are going to keep betting against the yuan. I do not see why people would stop betting against the yuan. As long as people are selling yuan and buying U.S. dollars, then the central bank will intervene. How long will they let the foreign exchange reserves decline?”

Biswas believes the yuan could fall significantly more if left to market forces. “Our view is it could go down a bit more, but there is a risk it could fall more substantially. If they stop defending it, it could fall quite rapidly.”

Not all of the capital outflows are driven by speculative investments, notes Kuijs. Many Chinese companies are reconsidering their financial plans given the change in the exchange rate and repaying U.S. dollar-denominated loans.

“That kind of outflow is not worrisome. They will not continue,” Kuijs says. But individuals seeking to shift into U.S. dollars because they do not trust the yuan are a bigger concern. “Those capital outflows are much more problematic. I cannot cite the exact percentage that is particularly worrisome, but it is definitely less than half of the outflows.”

Some experts worry that flight of private capital may be politically driven by President Xi Jinping’s ramped-up anti-corruption drive. Many wealthy Chinese, and even intellectuals, may be worried enough about political risk that they are finding ways to get their cash offshore in case they, too, leave the country.

People are taking a lot of money out of China despite the capital controls after it became apparent that the authorities were going after rich individuals in a way they had not done for many years, says Franklin Allen, a finance professor at Wharton, who is also executive director of the Brevan Howard Centre and professor of finance and economics at Imperial College London.

All agree there is a limit to how long China can continue to defend the yuan, despite the giant pool of $3.23 trillion in foreign exchange reserves as of January 31. That is still the world’s largest despite a net loss of $670 billion since June 2014. “How much do they want their reserves to fall? If they keep defending the yuan, the reserves will go down. If they do not defend it, speculators will push it down very dramatically, which could create panic in the market. There is no easy solution,” Biswas says.

Tightening for Now

Meanwhile, the Chinese government has begun tightening capital outflows in various ways, including on the RQDII or Renminbi Qualified Domestic Institutional Investor investment scheme (China rolled out the RQDII scheme at the end of 2014 to allow domestic institutional investors to buy assets denominated in yuan in the offshore market) and underground banking.

“Tightening capital controls on local residents, particularly the $50,000 annual quota on currency conversions, will provide more bang for the buck compared to tightening restriction on foreigners,” said Societe Generale Cross Asset Research Paris-based China economist Wei Yao. But given the yuan’s newly acquired SDR status, the PBOC might be hesitant to take too many steps away from capital liberalization related to foreign portfolio investments, Yao wrote in the “On Strategies for a CNY7.5 World” report.

Yao expects Beijing to keep tightening until the outflows are brought under control. Yao said Societe Generale’s baseline scenario, with a 65% probability, is for a gradual and controlled depreciation to 6.8 yuan against the U.S. dollar by the end of 2016, but its risk scenario, with a 35% probability, is for a rate of 7.50 yuan to the dollar by year-end.

Looking ahead, Minyuan Zhao, a management professor at Wharton, says she expects the Chinese central bank to tightly manage the exchange rate, rather than leaving it to market forces, while closely monitoring capital flows. In the meantime, the PBOC needs to choose between keeping the yuan’s rate against the U.S. dollar as its benchmark or focusing on its rate against its basket of major currencies, as it now claims to do.

“If the Chinese renminbi is pegged to a basket of currencies, it should weaken against the dollar, as some of the basket currencies are depreciating even faster. However, everyone is looking at the dollar now. Any depreciation against the dollar may trigger further capital outflows, which adds to the challenge (and cost) of maintaining stability,” says Zhao.

“They have not understood what it means to let the market allocate the resources. They still want to control a large degree.”–Franklin Allen

For now, given the recent market volatility, the consensus is that full convertibility of the yuan is not on the agenda. “Stability is more important,” Zhao says. Experts are wary of the potential disruptions to the economy that could ensue, having observed Japan’s tribulations with the upward and downward fluctuations of the yen, which swung between about 75 yen to the dollar to over 125 yen to the dollar in just over four years — and now is gyrating between 110 and 120 yen to the dollar, says Yukawa. “If there is such a wide currency fluctuation, the Chinese economy will collapse,” Yukawa says.

Assuming the authorities are able to keep the currency under control, economists expect China to manage an orderly transition to slower growth. Chinese growth slowed to 6.8% in the fourth quarter of 2015 and 6.9% for the year, the slowest pace in 25 years. The transition to greater reliance on consumption and services, instead of manufacturing and construction, is a challenge faced by many maturing economies, says Zhao. “I think there is still great potential once the adjustment runs its course in the future, as long as short-term policies are not in the way.”

In the coming year, Kuijs anticipates a somewhat slower pace of growth, but one that is still much faster than in the U.S. and Europe, at 6.3% in 2016 and 6% in 2017. China’s leaders have the ammunition and the policy space to ensure growth remains steady by adjusting spending. “The room for monetary easing has been reduced recently because of concerns about fast credit growth and the weakening currency. That is why fiscal policy is becoming more important in China,” Kuijs said.

While they tinker with policy in Beijing, Chinese leaders also need to improve their communication to help calm jittery markets. “What is most worrisome for outside investors is we are not sure what the Chinese policymakers are trying to do with policy over the currency, stock market and economy,” Yukawa says. When officials say they want a stable yuan, they need to explain if they are talking about its rate against the dollar or against the currency basket. “They need to explain more clearly to outsiders. That is why they are experiencing currency turmoil whenever they announce any negative economic indicators.”

Bottelier says he does not believe Beijing is seeking to push exports higher with a cheap yuan. “They want to get away from the dependency on foreign markets, so they want to avoid a significant depreciation if they can,” Bottelier notes.

But China’s policymakers are struggling with conflicting goals: wanting to move to a more market-driven exchange rate system and open capital accounts, but also seeking to avoid losing control. “They have not understood what it means to let the market allocate the resources. They still want to control a large degree. That is the thing they are struggling with,” says Allen.

Such contradictory aims, and the high stakes of failure, are the reason Beijing’s currency liberalization policy has moved at a glacial pace until now. “The conflict is between two major components of the Chinese economic reform agenda and that is the heart of the problem,” Bottelier says.