China slows yuan slide and will have ‘limited room’ to weaponise in future
Devaluation of yuan welcomed by central bank but Beijing ‘will have limited room’ to use currency as a defensive weapon in future, economist says
China was successful on the first day of its effort to stop the recent sharp decline in the value of its currency, the yuan, by raising the cost of foreign exchange speculation.
The onshore yuan was trading at 6.84 to the US dollar at the official market close on Monday, stronger than the daily parity rate set by the People’s Bank of China (PBOC) at the start of the day.
The rebound started late on Friday night after the central bank said it would reinstate a 20 per cent reserve requirement ratio (RRR) for purchases of foreign currency forwards, which will raise the cost of buying them.
Earlier on Friday, the yuan had fallen to a 14-month low of 6.91 to the US dollar because of China’s trade tensions with the United States and slower economic growth.
“That [the RRR increase] is a pretty clear signal of ‘enough’ – we do not want more devaluation,” Zhou Hao, a senior emerging markets economist at Commerzbank, said.
“I would say the recent devaluation that has sent the yuan from 6.3 against the US dollar to 6.9 is more or less welcome, or at least tolerated by the central bank, as it did help to offset pressures including those brought on by the trade war with the US,” he said.
But in the future, China “will have limited room” to use currency devaluation as a defensive weapon as a further weakening would trigger more negative effects, ranging from capital outflows to inflation high enough that it could discourage consumption, he said.
Eva Li and Hong Liang, analysts at China International Capital Corporation, agreed.
“The move indicates the central bank’s uneasiness with the recent rapid depreciation of the yuan … as unhinged exchange rate expectations might result in capital outflows and so deplete base money, which would add to the complexity of the conduct of current policy,” they wrote in a note issued on Saturday.
Monday’s gain notwithstanding, the PBOC’s action “arrived late”, so it remains unclear whether it will be sufficient to reverse yuan depreciation expectations, JPMorgan said in a note. If the currency resumes its fall, the central bank is likely to resort to stronger measures, including possible direct purchases of the yuan to bolster its value.
Beijing has introduced a series of easing measures in recent weeks designed to help cope with the rising pressure on economic growth caused by the government’s efforts to cut financial risk and the ongoing trade tensions with the US.
The adjustment of the RRR on Friday was the third time since September 2015 that the central bank has used it as a way to offset pressure on the yuan.
“The PBOC last imposed a 20 per cent RRR on foreign exchange forward transactions on September 1, 2015 when the onshore yuan was facing severe downward pressure,” the CICC note said. “The RRR was removed two years later in September 2017 when the yuan had stabilised for a few months and foreign exchange outflows had stopped.”
Reimposing the RRR on foreign exchange forward purchases will increase transaction costs for financial institutions that facilitate such purchases by selling onshore yuan.
As the central bank does not pay interest on the RRR deposits it holds and financial institutions’ funding costs stand at 3-4 per cent, imposing a 20 per cent RRR will increase the opportunity cost of buying foreign exchange forwards by 60-80 basis points, a significant amount for such transactions.
But the RRR also has a negative side effect. While it will discourage speculative selling of the yuan, it will also add to the cost of importers’ and exporters’ routine exchange rate hedging activities.
The yuan has weakened by about 9 per cent against the US dollar since its 2018 peak of 6.27 in March.
Some analysts have argued that China is using a cheaper yuan as a weapon to offset the headwinds brought by tariffs imposed by the US on Chinese imports, as it will allow exporters to reduce the base prices of their goods.
US Treasury Secretary Steven Mnuchin said last week that “the weakening of the currency creates an unfair advantage for them”, and that the US was “going to very carefully review” whether China had manipulated its currency.
He might have been referring to the twice-yearly report the Treasury produces for Congress on currency manipulation, the next issue of which is due on October 15.
The US Treasury has refrained from naming China as a “manipulator” in previous reviews, despite US President Donald Trump’s campaign promise to do so as soon as he took office in January 2016. In a speech in April 2017, Trump said that China was not a currency manipulator.
If the US Treasury does name China as a currency manipulator, it is required to spend a year trying to resolve the problem through negotiations.