A financial safety net should be established to prevent drastic exchange rate fluctuations and facilitate cross-border business

The yuan's recent drastic depreciation against the US dollar has underscored the need for China to set up an exchange rate stabilization mechanism and construct a financial defense framework to prevent drastic rate fluctuations and possibly damaging capital flows.

Since mid-February, the yuan's spot exchange rates against the dollar in the onshore and offshore markets have suffered continuous depreciation, changing the years-long one-way appreciation trend. The new round of deprecation was originally believed to be a result of rate interventions by China's central bank, however, the yuan's higher central parity than its spot rates in recent rate fluctuations indicates that recent depreciations did not result from the authorities' intentional interventions, but came from the impact of a fluctuation in global liquidity as a result of the US Federal Reserve's quantitative easing tapering.

The influence of fluctuating capital flows was reflected in other emerging markets after the Fed's announcement of its second QE reduction in late January, when Argentina, Turkey, South Africa and other emerging markets witnessed large-scale sell-offs of assets by foreign capital, the second fierce market fluctuation emerging countries have experienced since May. The recent continuous decline of the yuan's value in the offshore spot market is to a large extent believed to be the third impact on emerging markets caused by the Fed's QE withdrawal. In terms of the size of its cross-border trade, deposit and bond issuances, the yuan's offshore market is still at a small scale and thus bears the brunt of cross-border capital flows. The eight-month low the yuan has hit in its value against the dollar fully indicates the sharp decline of the offshore yuan positions and the large scale of the capital outflow.

The outflow of capital and the yuan's exchange rate depreciation will possibly further trigger an outbreak of foreign debt risk. Some of China's enterprises, especially real estate developers, taking advantage of the yuan's appreciations in recent years, issued large volumes of bonds overseas last year and the momentum continued in the first months of this year. By the end of the first 10 days of February, China's housing enterprises had issued a $7.9 billion debt in the global market, 38 percent of the total debt borrowed by world's housing companies.

With rising expectations for the yuan's appreciation, the foreign debt risk will also further increase. The Fed has said it will slash its monthly asset purchases from $65 billion to $55 billion in April, and may start to raise interest rates in early 2015. The dollar's narrowing interest rate and exchange rate gaps with the yuan will possibly further promote capital outflows from China. In view of the dollar's important role in global liquidity, China's contracting funds outstanding for foreign exchange will inevitably result in the shrinking of its pool of funds. That means the situation, whereby an ever-expanding foreign reserve has propped up the expansion of the domestic capital pool, will change and will add pressures to the yuan's depreciation and aggravate concerns over China's economic prospects.

For emerging economies, the fragility of their financial system and their fully floating exchange rate mechanisms have increased the possibility for the outbreak of financial risks, as indicated by interrelations between the Asian financial crisis and the region's financial liberalization. Under the push of the Washington Consensus and the International Monetary Fund, the world experienced a peak in capital account liberalization in the 1980s and 90s. In this context, developing countries represented by Southeast Asian and Latin American countries spared no efforts to introduce foreign capital to boost their economic development. However, the failure to set up a capital regulation firewall and lax management of capital outflows resulted in the eruption of the crisis, especially in countries with a high foreign debt ratio, a large current account deficit and insufficient foreign reserves.

The Impossible Trinity theory says that a country or region cannot realize an independent monetary policy, a free capital flow and a stable exchange rate at the same time, and that the realization of any two targets must be based on the abandoning of the one remaining. The large-volume international capital inflows and outflows truly comply with the principle of the free flow of capital, but they will have direct impacts on a country's exchange rate and monetary market.

Short-term speculative capital and its arbitrage activities on the yuan in recent years have brought huge risks to China. To avoid a precipitous fall in asset prices and a possible capital exodus, the country's monetary authorities should tighten management of the yuan's exchange rate in the onshore and offshore markets, keep a close watch on the chain reaction caused by the yuan's depreciations, and, if necessary, put in place a Tobin tax and strengthen the early warning mechanism for capital flows.

China should also strengthen international financial cooperation to deal with a new round of risks. It should also deepen financial cooperation with regional members to jointly deal with the effects brought by the US' QE withdrawal and changes in the global financial pattern, and accelerate the building of the Chiang Mai Initiative, multilateralization and other agreements aimed at promoting Asian financial stability. At the same time, a self-managed common foreign reserve fund should be set up with regional countries to accelerate building a regional financial safety network to maintain financial stability of China and Asia.