The liberalization of China’s currency and capital account is under threat as the renminbi (RMB) falls, capital outflows intensify and foreign reserves dwindle. Will the country forge ahead with its reforms or pause to allow the market to settle down? Both, in our view, have their pros and cons.

China’s policymakers face a major conundrum: as the RMB’s volatility has increased, capital outflows have intensified and depletion of foreign reserves has accelerated (down some US$663 billion from their June 2014 peak) as a result of market intervention to stem the RMB’s precipitous decline.

Consequently, Beijing needs to address the “impossible trinity” problem—that is, the fact that no government can control interest and exchange rates while allowing free capital flows.

If capital flows are not to be restricted, a government can choose to pursue a stable exchange rate and forgo an independent interest-rate policy (as local rates will need to move in tandem with world interest rates), or set interest rates but give up direct control of the currency (because the exchange rate will be determined by fund flows, which will be driven by interest-rate differentials).

Alternatively, a government can control both interest rates and the exchange rate, in which case it will need to close the country’s capital account.

The bottom line is that only two of the three elements can be controlled; something has to give. Historically in China, the currency and the capital account have been mostly quite rigid, enabling domestic monetary policy flexibility.

Depreciate, or De-Liberalize?

But the present government’s policy of liberalizing the currency and capital account creates only inconvenient options in the face of persistent capital outflows: allow the RMB to depreciate freely, raise interest rates high enough to defend the currency (at the cost of sabotaging growth) or just shut down the capital account again.

China has never been in favor of “big bang” reform and, with almost US$4 trillion of foreign reserves, appeared able to implement liberalization at a measured pace. Current global market volatility, however, shows that the “China impact” of steady liberalization was underappreciated, and the country’s spending of vast amounts of foreign exchange reserve dollars to combat capital outflows is now being questioned.

While we are monitoring the volume of China’s foreign currency reserves during this battle, we have few concerns about a massive drainage of domestic liquidity that would squeeze up interest rates. China’s high reserve requirement ratio of 17%, which was put in place during previous episodes of foreign liquidity inflows, can now be reversed steadily to release sufficient liquidity to offset capital outflows.

Essentially, China can let the currency truly float, fulfilling market expectations, or can resort to capital controls (euphemistically termed “macroprudential measures”) to stop the bleeding for a while. Either way, there are consequences to bear.

If Beijing chooses the path of currency depreciation, the currency might overshoot on the downside if fears in the market intensify. It’s also debatable whether a cheaper currency can really boost export competitiveness when global demand is so sluggish: currency depreciations in South Korea, Taiwan and Singapore over the past year have done little to boost their export performances.

Major currency depreciation will also increase external repayment risk for Chinese corporates, many of which took on significant offshore debt when the RMB was more stable and predictable.

It’s debatable whether macroprudential measures will actually work well, although policymakers in a number of other countries are applying them. There are clear risks, such as the damage to the credibility of China’s push toward a more free-market economy. But if such measures do work, China can let things calm down and restart the reform push when market conditions improve.

Some De-Liberalization Looks Likelier

We’re not forecasting a big devaluation of the US dollar, nor do we expect the People’s Bank of China (PBC) to start a depreciation of the RMB against a broad currency basket; if it did, the RMB would fail to gain much credibility as a reserves currency. Indeed, the central bank has recently emphasized reference to a basket of currencies, and despite the volatility of the RMB’s exchange rate against the USD, RMB levels against the basket have been quite stable. We think this stability will remain the policy objective in the near term (Display).

In our view, there is already evidence that the PBC is leaning toward scaling back its capital account liberalization. For example, it announced a ban on foreign banks from conducting cross-border foreign exchange transactions and arbitrage activities for three months.

Moreover, controls on the amount of money that local residents can take out of the country have been further tightened to RMB50,000, and the PBC is said to be considering new tools to narrow the gap between the CNH (offshore) and CNY (onshore) markets with more blatant and direct intervention measures in the market.

In terms of our forecast for the RMB, our base-case projection is that the PBC will keep the RMB stable against the currency basket, while the USD’s uptrend will peter out in 2016. In this scenario, we think CNY/USD will be around 6.60 on a six-month horizon (against 6.58 currently).

The CNY’s relative value against CNH/USD will remain volatile, but we expect the PBC to step up its effort to reduce the gap between the two markets, limiting the deviations.

This article appeared previously in the Financial Times.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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