Capital Controls Won't Save the Yuan

China's financial markets are caught in what some are calling "the perfect storm." It's been roughly six months since the situation dramatically escalated. As of yet, there are no signs of a calming sea.

Thus, there are more and more very vocal voices calling for China to enforce capital controls to save the Yuan. The intent is to keep the Chinese dragon from losing its balance.

This move may not mesh well with China's plans to liberalize its economy, but it's really not a bad idea. While it might help stem the crisis in China's financial system, it's unlikely to save the Yuan from plunging lower.

China Wants Capital Controls

Once again it's no other than Haruhiko Kuroda, the BoJ Governor, who is setting the wheels spinning. Kuroda, a regular star in our column and well known for his market-moving surprises, dropped a bombshell in Davos. In his speech, Kuroda suggested to his Chinese counterparts that they impose capital controls to curb capital flight.

While Kuroda might have overstepped, he nonetheless acknowledged the elephant in the room. In fact, though, Kuroda is absolutely right. China does need capital controls. And perhaps even wants it.

China, just like the market, wants a weaker Yuan to help revive its economy. It's well known that, in the long term, Beijing's goal is to transform China into a consumer-based economy like the US. Even so, China realized it needs to ease the pain and make the transition more gradual than previously thought. In order to lessen the pain, it needs the Yuan to continue to weaken. The problem is to ensuring the Yuan's gradual weakening since a manic-like move could destabilize the Yuan's integrity.

To cushion the blow and make the depreciation gradual, China must use its Dollar reserves. That could keep the Yuan from total collapse. But every time China does so it dilutes its currency reserves, and that could be dangerous.

The answer to the problem, as blatantly suggested by Kuroda, is capital controls. If China imposes capital controls and limits the pace of Yuan selling, the Yuan could depreciate gradually. Then there would be no need to use the reserves. Essentially, the capital controls would do most of the work. That would allow China to maintain its current level of reserves while stabilizing the economy.

Russia As A Case Study

Some argue that if China's government imposes capital controls, it would contradict its own declarations. Therefore, the implementation of capital controls is less likely. However, that assumption is wrong, because it assumes China would "officially" impose capital controls.

In fact, China could take a lesson from Russia's playbook. A year ago Russia was facing an even greater crisis than China's current one. The Russian government pledged not to impose capital controls. Meanwhile, they secretly "persuaded" local corporations to convert their Dollars to Rubles thus they effectively avoided purchasing Dollars. "Officially," Russia kept its promise by not imposing capital controls, but "unofficially" was a very different, albeit effective story.

The Chinese government might decide to do the same thing. In fact, this seems to fit the rather centralistic nature of Xi Jinping's government.

Yuan To Move Lower Slower

Unlike Russia, China's economic base is much stronger. Capital controls alongside other measures could finally bring some calm. But this will not prevent the Yuan from weakening. China still has no choice but to move to a weaker Yuan in order to stabilize the economy. What Beijing will do is allow China's financial system to stabilize so that Yuan selling will be gradual. That would help avert the panic-driven meltdown experienced by many Asian countries back in the '90s.

Look for my post next week.

Best,
Lior Alkalay
INO.com Contributor - Forex

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.