Since June 1, the Chinese yuan has depreciated by 6 per cent against the US dollar. This depreciation has been sharp, reminding investors of the “yuan tantrums” of August 2015 and January 2016. Will Beijing use the yuan as a mercantilist tool to counter the impact of the protectionist measures from the US? Is the Chinese economy still healthy, or does this yuan depreciation – as well as weakness in the Chinese equity markets – signal a more sinister outlook for China? Could the yuan experience the types of market-destabilising and sentiment-sapping depreciations seen in 2015/16?
Not really. It will be quite unlikely for the Chinese authorities to adopt a mercantilist yuan policy when it has avoided doing so since the 2005 yuan float. Most of us remember how Beijing bravely held the line on the yuan during the 1997 Asian Crisis. As in 1997, this is a prime opportunity for China to build on its soft power to help turn the yuan into a genuine international and reserve currency. The value to China from branding the yuan as a nominal anchor rather than a source of instability seems much higher than potential short-term gains, if any, from a maxi-devaluation.
Let’s put the recent yuan depreciation into perspective. The yuan has weakened by 5 per cent this year vis-à-vis the dollar, during which time the dollar index has appreciated by around 4 per cent against a wide range of currencies. While the movements in recent weeks have been uncomfortably sharp, the yuan depreciation hasn’t been outstanding, looking at year-to-date changes.
Second, the yuan is much more valuable to China as a nominal anchor. There is growing pent-up demand – of a healthy type, similar to what happened in Japan 30 years ago and in other Asian countries 15 years ago – for Chinese households to divest from their home (yuan) assets. At the same time, Chinese financial assets are significantly under-represented in international investors’ portfolios. After about US$1 trillion in outflows since 2014, there’s another estimated US$1.5-2 trillion of pent-up demand in China for foreign assets.
To prevent the lopsided capital outflows from triggering more spasms in the currency markets, Beijing will need to do more than just maintain tight capital controls, it will need to proactively promote Chinese financial assets to foreign investors. Stable yuan expectations would be a necessary condition for this.
Further, concrete signs of the yuan being used as a mercantilist tool could trigger a retaliation in kind from the US. Remember the last time the US focused heavily on its current account deficit, in the mid-1980s, culminated in the 1985 Plaza Accord in which five Western governments agreed to depreciate the US dollar in relation to the Japanese yen and German Deutsche Mark by intervening in currency markets. This trade war could easily degenerate into a currency war if one is not careful.
China’s economy is too big for the yuan to be a mercantilist tool; its financial markets are too big for the yuan not to be a nominal anchor.
Third, the just-commenced policy easing in China is pre-emptive. There are not yet signs of a meaningful deceleration in economic growth in China. This policy easing is to help inoculate the domestic economy in the event of an escalation in trade tensions, and to offset any negative effects from the ongoing de-levering and de-risking.
The bigger role of fiscal stimulus, relative to monetary stimulus, suggests Beijing is sensitive to the impact of its policies on the yuan, especially against the backdrop of a hawkish Fed.
But there are risks to a sanguine outlook on the yuan. The Sino-US trade “negotiations” are likely to be a 10-year – rather than 10-month – affair. China will play the long game, making compromises in the short term. This is likely to be a protracted struggle; a monotonic, rapid escalation in tensions beyond what has happened thus far seems unlikely. Nevertheless, if not, the yuan could suffer. Rising US inflation and a hawkish Fed may drive the dollar higher, regardless of what happens in China. This is another risk to the yuan.
One can see how the yuan could weaken further in the short term, but Beijing is unlikely to actively promote a yuan maxi-devaluation. If anything, expect policy measures to temper additional pressures on the yuan. Further, if there is a compromise on trade, expect the yuan to recover meaningfully. ■
Noted currency strategist, Stephen L Jen is chief executive of hedge fund Eurizon SLJ Capital and a former economist at the IMF