The real reasons the yuan fell had little to do with Chinese manipulation

Aidan Yao says that the recent sharp fall in the value of China’s currency has been driven by several factors, including the trade tensions with the US. Beijing’s focus from here on will likely be on fiscal stimulus, rather than run the risks that a major devaluation would hold

PUBLISHED : Wednesday, 01 August, 2018, 1:31pm
UPDATED : Wednesday, 01 August, 2018, 10:34pm

The recent sharp depreciation of the renminbi has ignited fears that Beijing is resorting to currency devaluation to fend off an escalating trade war with the United States. The yuan’s value vis-à-vis the dollar has fallen by more than 6 per cent since the middle of June. The CFETS RMB index has also depreciated by more than 5 per cent, suggesting that the yuan weakness was broad-based against peers in its trade-weighted basket.

Is Beijing competitively devaluing the currency to save its economy? Where will the exchange rate go from here? And how will the depreciation affect China’s economy?

On the first question, one has to realise that the yuan has only depreciated noticeably over the past six weeks. Before that, the exchange rate had been tracking the broad dollar move very closely up until mid-April and was resilient in light of the dollar rebound between mid-April and mid-June. Since the US Dollar Index has rallied by about 5½ per cent since mid-April, one could argue that the yuan was merely catching up to the dollar strength.

One obvious question is: why was the yuan so resilient between mid-April and mid-June, and only gave it all back in the last six weeks? Our hunch is that the exchange rate was supported earlier by the robust Chinese economic data, which only started to deteriorate in June.

In addition, foreign capital flowed to the Chinese market following the inclusion of yuan bonds in the Bloomberg Barclays Global Aggregate Index and ahead of A-shares’ MSCI inclusion. For a brief period, China was seen as a “safe-haven” when concerns over rising US dollar and interest rates swept across the emerging markets.

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However, the picture flipped rather quickly. As Sino-US trade tension escalated after Donald Trump went ahead with trade tariffs, the Chinese markets for foreign exchange and equity reacted immediately. A few domestic factors – weakening economic data, rising credit events and People's Bank of China (PBOC) easing policy, which narrowed the US-China interest rate differential – also added fuel to the exchange rate depreciation.

Did the PBOC also have a role to play in the devaluation? Not according to the data. China’s foreign exchange reserves barely changed, at around US$3.11 trillion, in the month of June, suggesting little in the way of official intervention in the foreign exchange market. The central bank has been fairly hands off in the yuan fixing, which has moved largely in line with market forces this year. If anything, central bank officials have tried to talk up the exchange rate, not pushing it down, at times when depreciation occurred too quickly.

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Where will the renminbi go from here?

The internal forces that have depressed the exchange rate will start to dissipate, thanks to recent policy adjustments that will support economic growth in the second half of the year.

The financial regulators have also taken their foot off the pedal on deleveraging to ease the credit market’s pain. Beijing understands that greater monetary easing may unsettle the exchange rate and has thus opted to keep monetary policy at a “neutral” setting and relied more on fiscal policy to put a floor under growth.

The external forces are more difficult to predict, not least because we have to anticipate Trump’s action on trade, but also the outlook of the US dollar is quite key for the yuan-dollar exchange rate.

The best guess is that additional tariffs on US$200 billion in Chinese imports, or at least part of that, will be implemented ahead of US midterm elections. But with the recent yuan depreciation already reflecting a lot of trade concerns, it is unclear how much more weakness there is to be priced in.

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Calculating the costs to China’s economy if the trade war escalates

Balancing out the different factors, the exchange rate is likely to be in for a period of stability, unless external conditions deteriorate dramatically from here.

Can the exchange rate depreciation offset the tariff impact? Yes and no.

On the macro level, analysis shows that a 1 per cent depreciation in the yuan trade-weighted exchange rate can boost export growth by 0.6 per cent after a three-month lag. Since the former has dropped by over 5 per cent since mid-June, the model implies a 3 per cent boost to export growth from the fourth quarter onwards.

If sustained, this boost will be worth US$68.4 billion of export gains, which will more than offset the cost of the US tariffs on Chinese imports.

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Yet, such a simplistic calculation does not account for, among other things, the distribution of gains across industries. The tariff-hit sectors (e.g. electronics and machinery) will still suffer because the foreign exchange gain is smaller than the tax increase, while the non-tariff-targeted industries will benefit from the full currency windfall without any offsets.

Finally, Beijing has to trade off the gains from foreign exchange depreciation against the costs of reigniting capital outflows. With the scar from the 2015 shock still fresh, Beijing will want to manage this double-edged sword carefully, by tightening the screws on capital controls if need to.

Overall, there’s little interest for Beijing to weaken the yuan intentionally and aggressively, which may risk undermining China’s financial stability and provoking more hostility from the US.

Aidan Yao is senior emerging Asia economist at AXA Investment Managers