Why China will avoid a big, destabilising yuan devaluation
Lawrence J. Lau says Beijing has the tools to avoid further abrupt and significant currency devaluations, since any effect on exports would most likely be outweighed by a loss of confidence both nationally and internationally in China’s future
The renminbi surprised world markets with its unexpected devaluations first in August 2015 and then in January. The devaluations affected confidence both domestically and overseas, and even contributed to the delay by the US Federal Reserve Board in raising the US interest rate. They also led to many rumours about a potential significant devaluation of up to 20 per cent. Many hedge funds are known to have taken large short positions against the renminbi, with some betting that the exchange rate will fall to as low as eight yuan per US dollar.
As Chinese economic growth slows, from close to 10 per cent to around 6.5 per cent, in transitioning to a “new normal”, the Western media have been almost uniformly negative about its prospects. Will the renminbi be devalued again? As both Premier Li Keqiang (李克強) and Bank of China governor Zhou Xiaochuan (周小川) have assured the public recently, and for the reasons laid out below, the renminbi is unlikely to devalue abruptly and significantly, although there may be small fluctuations.
A reliable indicator of whether a currency is overvalued is whether the balance of trade in goods and services is consistently negative. If a country consistently runs a large trade deficit, then its currency is likely to be overvalued. In 2015, China still had a sizeable trade surplus, in the order of 4.2 per cent of its GDP, or approximately US$450 billion a year, and is expected to continue to run a significant trade surplus in the foreseeable future. If any currency is overvalued today, it is probably the US dollar, not the renminbi.
It is well known that stable exchange rates facilitate cross-border trade and cross-border long-term direct and portfolio investment. Volatile exchange rates have the opposite effect. The Chinese economy needs relatively stable exchange rates to continue to grow and prosper. A devaluation of the renminbi at this time is likely to affect confidence both at home and abroad, and attract more currency speculation, leading to greater exchange rate volatility.
Would a devaluation increase Chinese exports? A small devaluation per se is unlikely to do so significantly even though it may increase the profits of Chinese exporters in renminbi terms, especially given that most world economies are either in recession, stagnation or a slow recovery. Moreover, in order for a devaluation to increase Chinese exports meaningfully, it may have to be in the order of 15 per cent or higher. But it is not really in the best interests of China to return to making garments, shoes and stuffed toys all over again, with the low standard of living that implies for its workers. Furthermore, the Chinese economy has also grown too large to be sustainable by increases in exports alone.
In addition, a devaluation is helpful only to the extent that potential competitors do not also devalue in response. If they do, then not only is no advantage gained, but the terms of trade will also deteriorate significantly. Instead, China would be much better off trying to move up the value chain in its exports, as Japan, Hong Kong, Taiwan and South Korea did before.
Moreover, for the Chinese people, it is even more important for the renminbi to retain its purchasing power, both domestically and abroad. A devaluation would have a direct impact on their confidence in the renminbi and the economy. It is also in China’s interests to promote the use of the renminbi as a medium of international exchange and eventually as an international store of value. All this requires a relatively stable exchange rate vis-à-vis the US dollar.
Finally, a devaluation that is not well communicated and/or justified can negatively affect confidence in the currency and by extension in the economy. A loss of confidence can lead to negative expectations about the future, which can be self-fulfilling, resulting in no or low economic growth, which in turn will confirm and reinforce the negative expectations, creating a vicious cycle. This is what has been happening in Japan for over two decades. It is critically important for China to avoid falling into such a trap.
The level of Chinese official foreign exchange reserves fell from almost US$4 trillion in mid 2014 to US$3.23 trillion at the end of January 2016. However, China still has the largest official forex reserves in the world. They amount to more than 18 months of Chinese imports, more than three times what the International Monetary Fund would regard as adequate. In addition, China also has an annual trade surplus of over US$450 billion and its annual inbound and outbound direct investment flows are approximately balanced. Under normal circumstances, the level of foreign exchange reserves should have risen by US$450 billion, the amount of the trade surplus. Instead, reserves declined by US$500 billion in 2015, implying a gross outflow of US$950 billion in 2015. Why?
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The gross outflow can be attributed to delayed repatriation of export proceeds, accelerated payment for imports, and other similar hedging tactics as a devaluation was expected. These hedging activities will result in a temporary surge in the outflow of foreign exchange, but most of it will eventually return because the exporters need renminbi to pay for their wages and expenses in China and importers cannot afford to prepay their imports further and further in advance.
When the public is convinced that the renminbi will not be devalued, hedging activities will be reversed, things will return to normal and the level of foreign exchange reserves should begin to rise again. There might well have been capital flight. However, capital flight is mostly one-off – because capital can only leave once. What is clear is that the US$500 billion net decline cannot be recurrent. Moreover, China is supposed to still have capital controls in place. The existing laws and regulations on capital control can and should be more strictly enforced.
Finally, to the extent that Chinese cross-border trade can be conducted directly in renminbi, China can manage with a lower level of official foreign exchange reserves. Starting from virtually zero in the first quarter of 2010, Chinese cross-border trade settled in renminbi amounted to an annualised rate of US$1.1 trillion, or 26.4 per cent of total Chinese cross-border trade, by the fourth quarter of 2015. (Actually, the proportion of Chinese cross-border trade settled in renminbi reached 32.4 per cent in the third quarter of 2015, and would probably have grown higher were it not for the unexpected devaluation in August 2015.) This should potentially reduce the reserves required significantly, by approximately a quarter.
Based on the above analysis, it is possible to conclude that the current level of official foreign exchange reserves is quite adequate.
Since the renminbi is not overvalued, and a devaluation is not in the best interests of China, and China has the ability to stabilise its currency, it is unlikely that the renminbi will devalue. However, there may be small fluctuations in the exchange rate. In fact, even though the renminbi has devalued relative to the US dollar during the past year, it has actually appreciated relative to most other currencies. Measured against a trade-weighted basket of currencies, the renminbi is almost exactly where it was at the beginning of 2015.
Lawrence J. Lau is the Ralph and Claire Landau Professor of Economics at the Chinese University of Hong Kong. This article is abstracted from a working paper of the Institute of Global Economics and Finance. See www.igef.cuhk.edu.hk/ljl