China’s Currency Depreciation Is Not An Opening Salvo In A Currency War

HAVING SIGNALED AS recently as late last month a widening of the yuan’s trading band, authorities have opted for a ‘one-off’ devaluation of the currency. The People’s Bank of China on Tuesday set its daily fix 1.9% lower than the previous day, its biggest daily shift since introducing the system, and taking the currency to a three-year low.

At the same time, the central bank said that future fixes would pay more heed to both the previous evening’s closing price and movements in the foreign-exchange markets. It will also seek to drive closer convergence between on- and offshore exchange rates.

This Bystander retains the view that these changes are primarily steps in the direction of eventual full convertibility of the yuan rather than a ‘currency-wars’-sparking devaluation to bolster exports and thus boost the slowing economy. Rebalancing the economy and securing IMF SDR status remain higher policy and propaganda priorities. Both require liberalised foreign-exchange markets.

As the chart above shows, the currency has been moving modestly lower against the dollar since the beginning of last year having seen a steady appreciation for the previous eight and a half years. However, as the chart also shows, the central bank has been holding a lid on that depreciation most recently, probably for fear of destabilising capital outflows.

In the short term, the central bank’s unexpected policy change will likely let the currency drift lower than it would otherwise have done. But the key point is that depreciation — and its reversal if and when it comes — will be driven more by market forces than administrative fiat.

SDRs And The Yuan’s Status As A Global Currency

MILESTONES ARE IMPORTANT markers. Case in point: the International Monetary Fund is likely to include the yuan in its currencies basket when it reviews the components of its Special Drawing Rights (SDRs) later this year.

The IMF’s determination in May that the Chinese currency is fairly valued was a straw in the wind. The Fund’s position stands in contrast with much opinion in the United States that Beijing manipulates the exchange rate to favour China’s exporters.

Once that may have been true, but no longer in any more than the most tangential way. Beijing has allowed the currency to appreciate for the past decade to get it close to ‘fair value’ through small but regular increments constrained by a daily trading band. The yuan has risen by some 25% over that time against the dollar.

That appreciation is the precursor to what may prove to be the most significant event in foreign exchange markets since the introduction of the euro. Beijing has been steadily but cautiously moving towards making its currency freely convertible and carefully opening up its capital account to that end.

That policy is also an important component of the broader policy priority of rebalancing of the economy. The yuan is now the world’s fifth most used currency, but still has a lot of ground to make up on the dollar and the euro.

To an extent, ‘internationalising’ the yuan is a potent way for China’s leaders to reflect the country’s growing power onto one of the biggest global financial markets and in doing so challenge the dollar. But it is also an inevitable consequence of the greater integration of China’s economy with the global economy.

The course of that consequence is clear: from paying for goods and services; to being a currency for global investment; and finally, the ultimate accolade, becoming a ‘reserve’ currency. 

Last year, more than 20% of China’s trade, or 6.5 trillion yuan, was settled in China’s currency. The forecast is that that proportion will pass one-half by the end of this decade. The yuan is now the world’s fifth most used currency behind the yen, pound, euro and dollar, up from 20th-most used as recently as 2011.

However, as an indication of how much ground the yuan still has to catch up, it accounts for 2% of global payments. The dollar accounts for 45% and the euro 28%. Closing those gaps will require a significant change to commodities pricing. The dollar rules that roost, especially energy contracts.

Offshore RMB clearing banks — they now exist in Canada, Qatar and Chile among half a dozen countries plus Hong Kong — are a key step in encouraging investment in yuan and greater use in trade finance. The RMB clearing banks increase pools of offshore liquidity that in turn encourage the creation of investment products.

The One Belt One Road initiative will similar boost yuan usage. The yuan-denominated loans that Beijing is making to support this infrastructure framework of overland and maritime connections to Europe will find their way back to Chinese suppliers of construction, engineering and financial goods and services. The process will repeat for providers of other goods and services such as logistics, insurance and finance as trade multiples along the new routes.

This development will mirror on a larger scale what is already happening with outward Chinese foreign direct investment, about one-third of which is now yuan-denominated.  Free-trade zones in Guangdong, Fujian and Tianjin, modeled on the one in Shanghai, will further boost this. Bit by bit, cross-border use of the yuan is being built up.

In the wake of the 2008 global financial crisis, Beijing put in place currency swaps with more than 30 other countries to ensure a rapid freezing of dollar credit markets would not again hurt its exporters. Though these, thankfully, have not been much used, they have symbolic importance for Beijing’s push to promote the yuan’s greater use in trade finance.

Just as symbolic has been the increasing willingness of other countries to start including the yuan in their official foreign-exchange reserves. The People’s Bank of China estimated that foreign central banks held about two-thirds of a trillion yuan in their official reserves at the end of April. That sounds a decent chunk of change.

However, it would be less than 2% of the total, according to this Bystander’s back-of-an-envelope calculation. That compares to 4% for the pound sterling and 23% for the euro while the dollar’s share tops 60%. It will be decades before the yuan catches even the euro.

Yuan bank deposits outside mainland China have doubled since 2013 to some 2 trillion yuan — half of them in Hong Kong. A large part of the overall increase has been speculative money riding the currency’s appreciation. That play is over, crimping the growth in deposits. However, even 2 trillion yuan is a rounding error in the global total of bank deposits.

Investors also now have a growing range of yuan-denominated instruments beyond bank deposits from which to choose. Increasingly this includes domestic bonds and equities, not just offshore ‘dim-sum’ bonds. The pilot cross-trading of Shanghai and Hong Kong equity issues, which is all yuan-denominated, has been a boom in this regard. It will continue to expand, and Shenzhen stocks are expected to join the arrangement before too long.

The concept is being applied to mutual funds, too, again initially on a trial basis. At the same time, opportunities for Chinese investors to invest directly in overseas financial markets are gradually being expanded through the qualified investors scheme.

On some calculations, China is now a net exporter of capital.

For all the aspirations of Beijing and the real progress the yuan has made towards becoming a global currency, there is still an awfully long way to go. If the IMF does include the yuan in its SDR basket, as Beijing is lobbying for so hard if so discreetly, it will nudge the Chinese currency a little further down that road, but only a little bit.

A bigger question is, how much impact such a high-profile move would have on American companies that, as a class, do not conduct international trade in any currency other than their own, let alone China’s. In a U.S. presidential election season, when some candidates will want to be seen to be ‘tough on China’, it could prompt a backlash if the debate becomes a xenophobic ’the dollar vs. the yuan’.

A further, if less likely political risk, is that the U.S. uses its veto to block a decision to include the yuan in the SDR basket. That would be a confrontational move, far beyond Washington’s passive but notable absence from any support for any of the moves Beijing has made to expand the international use of the yuan.

Beijing has made a commitment to liberalise fully its capital account by the end of this year, and thus, to all intents and purposes, to the yuan being fully convertible. The economic reformers see that as a stepping stone to further opening of China’s domestic markets to foreign capital that will be necessary for overall economic rebalancing. There are vested interests that oppose full convertibility for just that reason.

China May Let Its Currency Drift, But It Is Not About To Fight A Currency War

THE STATE COUNCIL last week proposed some measures that suggest to some that China is ready to indulge in bald-faced competitive devaluation to boost exports and thus growth—even if it did not cast it in those terms.

The Council said that the People’s Bank of China should widen the daily band within which the renminbi can trade on foreign exchange markets. This Bystander recalls that the last time the State Council weighed in on the subject in public, in March last year, within a fortnight the central bank had expanded the permitted trading range to 2% either side of the mid-point it sets from 1%.

If history is prologue, that will open the way to a devaluation of the currency that authorities might be happy to encourage, manage or manipulate — you choose your description. That would represent an escalation from the general monetary easing policies the central bank has been following for many months.

That, at least, is one argument that is being made. However, the opportunity to devalue the currency and the will do so are not one in the same.

Furthermore, even those forecasting a devaluation have to answer two essential questions. First, how sharp would any devaluation be? Second, would it be sufficiently large to encourage retaliation particularly from regional trading partners — though some Chinese exporters may feel that Japan, in particular, has already got its retaliation in first having seen a 30% devaluation of the yen in the era of Abenomics?

However, exporters are not the ones making the decisions, and, arguably, their domestic political clout over such decisions is at its lowest ebb in many a year.

The policymakers who will be making the decisions about the currency know that boosting exports to goose growth is just as old-school a stimulus as infrastructure investment spending and undertaken to the detriment of rebalancing. That remains the greater policy priority.

China’s foreign-exchange regime has its part to play in that. It may not be a leading role, but equally it is not a solo performer.

For that reason alone, we expect any devaluation brought about by a widening of the renminbi’s trading band to be slight, more a downward drift than a devaluation. Moreover, any sharp weakening of renminbi could trigger capital flight at a time when the financial system is not in the best of shape to weather it.

Baby Steps In Qianhai To Internationalise The Yuan

China is making progress towards a test relaxation of capital controls in Qianhai Bay, the still largely unbuilt special business zone near Shenzhen and Hong Kong, the head of the National Development and Reform Commission Zhang Ping says. Zhang told reporters at the National People’s Congress that only half a dozen of some 22 issues remained outstanding so a currency pilot program could go ahead.

Zhang was confident these would be sorted out by mid-year. Reconciling the legal jurisdictions of China and Hong Kong when it comes to contracts would seem to be the most contentious one.

Under the pilot scheme, companies based in Qianhai will be free to borrow in yuan from Hong Kong banks at market rates. The companies will be exempt from requesting permission to import the yuan across the border; and the banks will not be required to lend to them at the official borrowing rates set by the central bank. Initially sums involved will be small. Total lending is to be capped at 2 billion yuan ($320 million).

It will be the first of what is intended to be several experiments in the freer convertibility of the yuan and interest rate reform. In time they may be seen to have been an important step in the internationalization of the currency. The hope is sufficiently strong for 15 international banks to be setting up branches in Qianhai. That in itself is another tiny step towards Hong Kong establishing itself as the yuan’s offshore trading centre.

New president Xi Jingping visited Qianhai late last year on his southern tour in his capacity as the Party’s new general secretary, suggesting the project has high-level backing. The trip was also a nod to his father, Xi Zhongxun, an advocate of special economic zones as Deng Xiaoping was first opening up China’s economy in the late-1970s. Shenzhen, the first, was famously described as a “commune of capitalism.”

Much as Shenzhen was a laboratory for China’s economic reforms of the past 30 years, so some pin similar aspirations on Qianhai for administrative and legal reforms along the lines of Hong Kong. In practice the pilot schemes are being more narrowly focused on finance, taxation, human resources, education, health and telecoms as incubators of service industries. But Qianhai can be regarded as another barometer of how far the new leadership feels it can push economic reform.

China: One Currency; Two Yuans

London has made more than one fortune on the China trade, though they have not all ended happily. Whether the yuan will end up as the new opium is the question raised by George Osborne, Chancellor of the Exchequer as the U.K. calls its finance minister, who has been in Hong Kong to promote a scheme to make London the leading international center for trading in China’s currency. London and Hong Kong have been talking about how to do this since last summer. Osborne’s trip will continue the talks.

Chatham House, a think tank in London, has forecast that trade transactions settle in the currency would reach the equivalent of $1 trillion by 2020. Yet, while Beijing has been taking baby steps towards making the yuan a fully convertible currency, there is still a long, long way to go. It remains an aspiration as much as anything but also a hostage to the pace of financial reform, which, as we have noted before, is in stasis during the leadership transition. China may need to rebalance its economy away from export- and investment-led growth and towards domestic consumption, for which financial system reform is a necessary if not sufficient condition, but vested political interests stand in the way. For all the wishful thinking in some parts, the Chinese currency is far from displacing the dollar as the world’s reserve currency, or even having the standing of the yen or the euro in such circles.

If anything, the surprise is that the offshore market for yuan is as large as it is (yuan deposits in Hong Kong total the equivalent of $80 billion). Normally the deepening and development of domestic financial markets and the easing of capital controls is prelude not postscript. In China, the first two are so difficult that the third is the easier option, even if by having a government controlled onshore yuan market in China and market driven offshore yuan market in Hong Kong and London, China may well end up, not untypically, with one currency but two yuans.

London, of course, will be happy to take its skim off both.

China’s Policymakers Smile On A Stronger Yuan

China’s policymakers may not be too sorry, for once, to see the yuan hit its highest value against the U.S. dollar since 1993. This week alone has seen the currency rise 0.7% against the greenback, its largest weekly jump in four years. By the standards that Beijing has imposed on the tight management of its currency, and its resolute opposition to letting the yuan appreciate except to its own timetable, it is a dramatic rise.

Long-term, it has always been in China’s interest (and policymakers’ plans) to let the currency appreciate towards market-driven levels in order to support the effort to reorient the economy away from export-led growth and towards domestic consumption. But a number of short-term factors have come together to make a stronger yuan desirable now.

It will help in the fight against inflation, which hit a three year high of 6.5% in July. It will slow the accumulation of dollar-denominated foreign-exchange reserves at a time when Chinese officials worry about the erosion of the their value in the face of the U.S. deficit debacle, and July’s trade surplus, the largest in two years, will swell them further. It, up to a point, would also pre-empt further inflationary impact on China of a further round of quantitative easing in the U.S., should the U.S. Federal Reserve may good on some hints that that might be necessary if U.S. GDP growth remains tepid, and, even more intangibly, it stocks up some international goodwill for Beijing as it makes China look to be a responsible team player in the face of a potential ‘double-dip’ global economic slowdown.

Most important of all, as far as the internal debate on the currency goes, appreciation would not be happening in the face of foreign, particularly U.S., pressure to let it happen. Whether there is a fundamental shift towards liberalizing China’s exchange rate policy about to happen, or, as seems more likely to us, a cautious step in that direction through, say, widening the bands within which the yuan is allowed to fluctuate each day, it won’t come without some cost to the rest of the world. The dollar, by definition, would fall and U.S. Treasury yields rise, if not disruptively; China would export some of its inflation. Many of these effects would, of course, net out across the global economy, such is the arithmetic of current accounts. How smoothly that would go depends as much as anything on what progress China can make in liberalizing its domestic financial markets. That is the biggest missing piece in making the arithmetic of canceling out the global imbalances work out.

April’s Trade Surplus Surge Is Ill-Timed

Bad timing. China’s trade surplus for April came in at a larger than expected $11.4 billion as exports surged and imports were lower than expected. Exports grew 29.9% year-on-year to $155.7 billion while imports rose 21.8% to $144.26 billion. The numbers were announced between days one and two of the latest round of the China-U.S. Strategic and Economic Dialogue being held in Washington. They will provide fresh ammunition for U.S. critics of China’s tight management of its currency and increase the pressure on Beijing to allow faster appreciation of the yuan. China’s defense, that it recorded its first quarterly deficit in seven years in the first three months of this year, will be overwhelmed, though the central bank has been allowing the yuan to rise as part of its own anti-inflation fight. What is complicating that for it is the fact that while the yuan has gained more than 2% agains the dollar in the past six months, it has lost ground against other leading currencies as the dollar has weakened.

Footnote: Note for the watch-list: does April’s weak imports number reflect a slowdown in the economy or a running down of inventories, particularly of price-spiked commodities?

China As Japan 1985 Redux, Or Not

The IMF’s latest World Economic Outlook left its projections for China’s GDP growth for this year and next unchanged at 9.6% and 9.5% respectively, a slight slowdown from the 9.8% by which, the IMF estimates, the economy grew in 2010 and ahead of Beijing’s own forecasts. A set of traffic light warnings on whether the economy is overheating are mostly at amber.

The Outlook also devotes a sidebar to the lessons of Japan’s bubble in the 1980s and the effects of the rapid appreciation of the yen, forced on Tokyo by the Plaza Accord of 1985. The piece starts by saying that “some argue that this is a cautionary tale, exemplifying the dangers of reorienting economies through currency appreciation” and sourcing the some to the People’s Daily, so it is pretty clear where the lesson is directed. Not that that is any surprise given that the IMF has long been a critic of China’s slow appreciation of the yuan, a process being tightly managed by Beijing because of the risk of social dislocation.

The IMF authors’ central argument is pretty clear: the rapid appreciation of the yen wasn’t the cause of the Japan’s “lost decades”. The sequence of events is unquestioned. The yen’s rapid appreciation stopped Japan’s export and GDP growth in its tracks; the government responded with a big stimulus package; an asset bubble was inflated that went pop in 1990 and the economy has essentially been becalmed since.

What is put at question is whether the stimulus was excessive (yes, say the IMF’s authors) and whether it alone was responsible for the bubble (no, they say; financial deregulation allowing a rapid expansion of bank credit for real estate investment and tardiness in reining it in were also to blame; two factors compounded first by the overleveraging of Japan’s banks that were at the heart of keiretsu, or groups of closely affiliated companies, and then by the political constraints on authorities forcing the keiretsu to restructure and write off their debts which didn’t happen for a decade, allowing time for further policy missteps and external shocks). In short,

The conditions facing Japan were in many ways unique, and the bad post-Plaza outcome was due largely to a credit bubble that developed after exceptional policy stimulus was combined with financial sector deregulation. When the bubble burst, exposing underlying vulnerabilities, political economy constraints meant that restructuring progressed too slowly.

The IMF says circumstances in China today are different from those in Japan in the 1980s so past won’t be prologue. First, China’s households, corporations, and government aren’t as overborrowed as were Japan’s pre-bubble. Second, China has more room to move up the export quality ladder than Japan did, which will help offset the impact on growth of currency appreciation (though risks labor dislocation in low-end export manufacturing), and third, Japan had a floating exchange rate regime in the 1980s, whereas China has a managed exchange rate supported by vast foreign currency reserves and restrictions on capital inflows. “This difference in currency regimes should help China avoid the sharp appreciation observed in Japan,” says the IMF. Which is exactly Beijing’s point.

Inflating The Yuan’s Value, Not Manipulating It

The U.S. Treasury has danced its way, as is its wont, around designating China as a currency manipulator. In its latest half-yearly report to the U.S. Congress, it says that China’s high inflation means that the yuan’s real (inflation-adjusted) exchange rate with the U.S. dollar has risen by an annualized 10% since Beijing started allowing its currency to rise again against the greenback last June. On a nominal basis the yuan rose 3.7% over that time.

Were the Treasury to declare that Beijing was manipulating its currency, it would trigger retaliatory actions by the Congress, where many believe that it does. That, though, would be a ramping up of Sino-American tensions that neither government would want to deal with, especially in the wake of President Hu Jintao’s state visit to Washington last month that put the relationship on a less overtly confrontational footing.

The Treasury did, however, repeat another of its favorite tunes, that the yuan remains “substantial undervalued” agains the dollar, and that more rapid progress is needed in its revaluation.

China’s real effective exchange rate has appreciated only modestly over the past decade. China’s large increases in productivity in export manufacturing, improvements in transportation and logistics, and China’s accession to the WTO all suggest that the [yuan] should have appreciated more significantly on a real effective basis over this period.

To seek to change that, the Treasury strikes a note of encouragement, rather than chiding:

It is in China’s interest to allow the nominal exchange rate to appreciate more rapidly, both against the dollar and against the currencies of its other major trading partners. If it does not, China will face the risk of more rapid inflation, excessively rapid expansion of domestic credit, and upward pressure on property and equity prices, all of which could threaten future economic growth. By trying to limit the pace of appreciation, China’s exchange rate policy is also working against its broad strategy to strengthen domestic demand. And China’s gradualist approach on the exchange rate also adds to the substantial pressure now being experienced by other emerging economies that run more flexible exchange rate systems and that have already seen substantial exchange rate appreciation.

Beijing’s policymakers know that that to be the case. They are just doing a slow foxtrot with the yuan for domestic social and political reasons, and won’t be rushed into picking up the tempo.

Unintended Consequences Of Yuan Revaluation

Our man with his ear to the ground moving and shaking the global elite at the World Economic Forum’s annual meeting in Davos sends word that amidst a general half-glass full/glass half empty sentiment towards China’s commitment to revaluing its currency, there is some concern that a revalued yuan against the dollar would be a mixed bag for U.S. firms. U.S. exporters would find their products becoming relatively cheaper in the Chinese market. In the other direction, American firms with Chinese operations would find their exports from China becoming relatively more expensive. Foreign-affiliates account for 54% of all China’s exports, according a finance ministry report last year. Against that, foreign affiliates would also be repatriating higher profits in dollar terms from their domestic Chinese sales, and their margins would be helped by getting cheaper raw materials when those are imported.

It is on the investment rather than trade account that a yuan revaluation may have the greatest unintended consequences. It would become more expensive for U.S. companies to invest in setting up Chinese operations, giving an advantage to those already there. It would also likely boost China’s outward foreign direct investment (FDI), as it lowers the cost to Chinese firms of buying overseas assets. This Bystander recalls that that is what happened in Japan after Washington arm-twisted Tokyo into allowing a 50% revaluation of the yen against the dollar in 1985-87. Japan’s overseas FDI went from barely $6 billion in 1984 to nearly $50 billion by 1990.

In China’s case, the drive overseas is led by the search for natural resources. Manufacturing accounts for less than 10% of Chinese firms’ FDI. Some labor-intensive manufacturers are looking abroad for cheaper labor in the face of rising wages at home; more than 700 Chinese companies had invested in operations in Vietnam as of last July, according to Vietnamese officials. That is a drop in the bucket of the country’s manufacturing cohort, and they are mostly small or low-value-added manufacturers from Guangdong and the provinces bordering Vietnam. Yet a rising yuan could sweep along more in their wake. If Japan’s experience were to be replicated (and Beijing has resisted such a rapid forced appreciation having seen the effect on Japan’s domestic economy), the bigger flood of Chinese firms looking beyond natural resources to invest in access to foreign markets, brands and technology would be likely to prove much more troublesome for Western competitors, and to expand trade friction into investment friction.