How a sliding yuan and volatile stock market have put China’s central bank in the hot seat
Nicholas Spiro says the US Federal Reserve seems determined to go ahead with monetary tightening but a sharp decline in China’s yuan might provoke a pause, as it did in 2015
As recently as the middle of last month, it was central banks in advanced economies which were under the spotlight.
The US Federal Reserve and European Central Bank, the world’s two largest central banks, both took measures to withdraw stimulus despite mounting concerns in financial markets about a policy blunder, made more acute by the Fed’s eagerness to push ahead with a faster pace of tightening in the face of the dramatic escalation in tensions over global trade.
The 3.4 per cent slide in the yuan against the dollar in the second half of June – a fall which JPMorgan, in a note published last Friday, described as “nearly unprecedented” and “only comparable in magnitude to the August 2015 [surprise] devaluation” – has once again turned China’s currency into a focal point of market anxiety.
That there is intense speculation that the yuan’s decline is being engineered and used as a weapon in China’s trade dispute with the US is adding to market tensions. Given the renewed sensitivity of international investors to movements in the yuan, concerns about the credibility of China’s policy regime – the key factor behind the sharp sell-off in global markets in the second half of 2015 – are resurfacing at a particularly inauspicious time for emerging markets.
A sliding yuan – whether engineered or not – in an environment of higher volatility, in which US interest rates are rising and the dollar is strengthening, is a major vulnerability. Not only does it increase the risk of a disorderly depreciation, it throws the tensions and weaknesses in China’s economy into sharper relief.
While there is none of the panic over capital flight which fuelled the 2015 sell-off, the People’s Bank of China’s ability to reconcile conflicting priorities – shoring up domestic demand which has slowed markedly this year, while at the same time pushing ahead with deleveraging while preserving China’s status as an anchor for the global economy – is being severely tested.
At least China still boasts a current account surplus (albeit a dwindling one) and has a war chest of some US$3 trillion to defend its currency should the selling pressure intensify. The same cannot be said for several other major emerging markets which have come under strain.
In Brazil, the real, the country’s currency, has plummeted 24 per cent against the dollar since the end of January, dragged down by a truckers’ strike that has dealt a severe blow to an economy that only recently emerged from recession.
Brazil’s central bank, which has been cutting interest rates aggressively in response to a sharp fall in inflation, is now under pressure to start raising them again as its interventions, in the form of swaps auctions, fail to halt the real’s slide. China’s economy may be slowing, but Brazil’s is mired in stagnation.
Yet, even Brazil is in a less vulnerable position than Turkey, the large developing economy most at risk from the tightening in financial conditions.
While headline inflation in Brazil and China is running at 2.8 per cent and 1.8 per cent respectively, it is has skyrocketed to 15.4 per cent in Turkey, a 14-year high. As is that were not bad enough, Turkey is heavily reliant on inflows of foreign capital to help fund a bulging current account deficit approaching 5.5 per cent of GDP.
Although the central bank raised rates aggressively in May in an effort to prop up the country’s wilting currency, the lira, Turkey’s autocratic president, Recep Tayyip Erdogan, vehemently opposes rate hikes, undermining the central bank’s credibility.
As I argued in an earlier column, these home-grown problems make it less likely that the Fed will relieve some of the pressure on emerging markets by slowing the pace at which it withdraws stimulus.
Still, renewed concerns about China’s currency have raised the stakes for the Fed.
Following the shock devaluation of the yuan in 2015, the US central bank cited financial instability in China as a sufficient reason to hold off raising rates for the first time in a decade. If the sharp declines in the yuan and Chinese stocks over the past several weeks are a foretaste of things to come, the Fed may have to think twice.
For the time being, however, it is the People’s Bank of China that is in the hot seat.
Nicholas Spiro is a partner at Lauressa Advisory