Foreign Exchange and External Sector Developments in China

China has experienced a number of episodes of capital flow and exchange rate volatility over the past 3 years. Meanwhile, the current account surplus has declined markedly together with net saving, while the real effective exchange rate appreciated. This note describes some aspects of these developments and explains how they relate to key features of the Chinese external sector and exchange rate arrangements. Despite market restrictions, periods of financial stress are typically associated with exchange market pressure on the Renminbi (RMB) and sudden stops in private capital inflows. In the second half of 2018, the RMB experienced a decline of 8 per cent against the U.S. Dollar (USD), raising fears that the period of financial market instability experienced in 2015 could be repeated. In our assessment, while current indicators provide little indication of further rapid RMB depreciation in the very short run, there are several risk factors that could trigger currency instability in the future. These risk factors include: i) an escalating trade war undermining Chinese growth; ii) internal and external pressure to liberalise financial markets jeopardising successful exchange rate management; iii) domestic financial market vulnerabilities undermining investor sentiment. Regarding potential international spillovers, although direct trade and financial linkages between China and Ireland are substantial relative to the latter’s linkages to other emerging market economies, Ireland is more heavily exposed to advanced economies. Finally, Hong Kong plays a critical role as a financial intermediary, such that a close examination of Hong Kong-China linkages is essential to understand China’s place in the global financial system.