China’s economy faces headwinds, but don’t fear another 2015 crisis

While sharp depreciation is unlikely, short-term pressures on the yuan will remain as China’s economy tries to rebound from the pandemic
Market watchers should keep an eye on China’s central bank and see how it tries to maintain support while also supplying monetary stimulus

David Chao

Published: 10:30pm, 12 Jun, 2022

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Recent turmoil in global markets have caused outflows from Chinese assets, while the country’s zero-Covid lockdowns have weighed heavily on the domestic economy. These factors, coupled with rising interest rates in the United States and higher commodity costs, have caused a rapid depreciation of the renminbi against the US dollar and marks an end to the currency’s 2020 appreciation cycle.

During the start of the Covid-19 pandemic, China’s economy outperformed those of other major economies, and the yuan strengthened because of a surging trade surplus and foreign capital inflows. Now, global growth is slowing and so is China’s export momentum.

The divergence between US and China monetary policy is widening, driving yield-seeking investors away from China. The recent depreciation might trigger memories of the dramatic sell-off in equity and currency markets in 2015.

This time, it is clear China’s fiscal and external positions are different. The 2015 episode was triggered in part by the “taper tantrum” as US monetary policy tightened and China faced significant capital flight because of elevated foreign debt repayments denominated in US dollars. Today, there is less pressure on servicing foreign debt and relatively effective capital controls in place supporting a healthy capital account.

In addition, China’s current account surplus has grown larger as global demand for Chinese exports remains robust and domestic demand has weakened. Chinese commercial banks built up ample foreign asset positions during the currency appreciation cycle in 2020-21 that should act as a buffer.

This implies the chances of a conventional financial or currency crisis are lower than feared and could help explain the strength of the onshore yuan. The trade-weighted China Foreign Exchange Trade System index is still close to 101, compared to pre-2020 range of 92 to 96, mostly because of the recent strengthening of the US dollar. This could mean there is further room for the yuan to depreciate and gives the People’s Bank of China (PBOC) more space to manage monetary policy easing without setting off a chain reaction.

The lack of support could signal that policymakers are taking a more hands-off approach towards currency intervention or that the PBOC thinks the currency is still overvalued. A weaker yuan benefits Chinese exporters, though I don’t think policymakers will tolerate a disorderly fall in the currency that could threaten the stability of the financial system.

Regardless, the same macroeconomic factors that are punishing Chinese financial assets weigh heavily on the currency as well. To ward off growth headwinds and a depreciating yuan, supportive policy actions are key to watch out for going forward.

The PBOC has vowed to keep liquidity reasonably ample, support weak sectors and plan for “incremental policy tools”. All eyes are on what actions policymakers take to stimulate household demand and investments. The recent reduction in the five-year loan prime rate is the latest step to alleviate pressure on the housing market and maintain liquidity.

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It’s notable that the PBOC has not done quantitative easing on the scale of the US and Europe, perhaps to provide some floor on further yuan depreciation. We’ll have to watch how the PBOC tries to provide enough monetary stimulus through this wave of the pandemic while also maintaining support.

Meanwhile, we can imagine more countries taking a second look at their reliance on the US dollar as the default currency for foreign exchange reserves. The yuan would be a natural benefactor of this, and we should watch closely how the foreign exchange mix shifts in the coming years.

There is plenty of chatter within China of how to end the US dollar’s dominance in international finance. As China’s economic development continues, the country and its trading partners will need to ensure global demand for the currency remains robust and supported by a diversified economy with an internationally accepted financial system.

A sign for digital yuan, or e-CNY, is shown at a shopping centre in Shanghai on May 5. Photo: Reuters

Beyond foreign exchange reserves, the digital yuan initiative should also streamline cross-border payments and facilitate more investment flows. Recent payments for Russian coal and oil in yuan could also presage further take-up of the currency. These catalysts should keep the yuan in its current position as one of the most-used currencies for global payments.

While sharp depreciation is unlikely, short-term pressures on the yuan will remain as the economy tries to rebound from pandemic uncertainties and aggressive tightening in the US. For the time being, the PBOC is unlikely to take a strong hand and hold the currency at a particular level. If volatility leads to too much capital outflow and depreciation pressures build, though, regulators are likely to defend the currency more robustly.

David Chao is Invesco’s global market strategist for Asia-Pacific

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