Right policy can help tide over tough year

The People's Bank of China faces a dilemma. After nearly a decade of trying to curb expectations of continued currency appreciation (spurred by China's current-and capital-account surpluses), it finally succeeded in the first quarter of 2014, when its forceful market intervention drove down the renminbi's exchange rate to discourage carry trades. Now, however, the PBoC is facing an even more difficult challenge, as seemingly irreversible depreciation expectations undermine economic stability at a time when China can least afford additional uncertainty.

Because the 2014 intervention coincided with the weakening of China's economic fundamentals, it ultimately amounted to pushing on an opening door. Instead of providing credible resistance to upward pressure on the exchange rate, as intended, it triggered an outright reversal, with depreciation expectations beginning to creep into foreign exchange markets.

Thus, in the second quarter of 2014, China recorded a capital account deficit for the first time in decades. And by the first quarter of 2015, that deficit more than offset the current account surplus, meaning that China registered its first international balance-of-payments deficit in recent memory.