Appreciate the yuan depreciation

This article was published in China Daily on 8 April 2014.

Since the beginning of this year, the renminbi has been depreciating against the US dollar. That marked a departure from the earlier trend of the Chinese currency appreciating against the US greenback since the exchange rate reform in 2005.

On Jan 15, the People’s Bank of China’s midpoint rate was 6.04 yuan for one US dollar. But by March 14, the same had fallen to 6.14 yuan. The bank announced that, effective March 17, the exchange rate would be allowed to rise or fall 2 percent from a daily midpoint rate set each morning by the central bank.

Since then the yuan has been on a downward spiral.

On March 21 the rate plummeted to 6.22 yuan. Compared with the exchange rate in mid-January, the yuan has depreciated more than 3 percent since then. However, the recent devaluation of the yuan is a rare phenomenon and there are several reasons for it.

Due to the US Federal Reserve’s quantitative easing policy, short-term capital has been flowing out of emerging economies since the second half of last year, and currencies of emerging economies have been facing devaluation pressures.

Changes in the international environment have also weakened the expectations for yuan appreciation. Since January, the appreciation trend has slowed, or even moved onto a plateau. It is obvious that these changes have played a major role in the current round of devaluation.

Recent macroeconomic indicators have also triggered fears about the Chinese economy in the mid-term. In February, the growth rate of China’s exports was minus 18.1 percent year-on-year. Even taking into account the effect of the Spring Festival, the numbers are still in the red. This is a major deviation from the earlier optimistic predictions.

In addition, during January and February, year-on-year growth in fixed asset investment was 17.9 percent, down 3.3 percentage points for the same period last year. More importantly, the added value of industrial enterprises’ year -on-year growth in February fell to 8.8 percent, the lowest growth since April 2009.

At the same time, risks of a partial financial crisis are gradually emerging in China. Following the late payment crisis of China Credit Trust, the first corporate bond default of Chaori Solar, and the debt repayment crisis of a real estate company in Ningbo, downside macroeconomic indicators have promoted rising financial market risk factors.

International capital invested in China with a high leverage faces the prospect of a decline in yields and rising investment risks. These factors also hampered short-term capital inflows.

China’s international payment imbalances are also further approaching equilibrium. In recent years, international net capital inflows and net outflows appear staggered, and the current account surplus has narrowed.

Among them, the current account surplus accounted for only 2.1 percent of last year’s GDP. In February, China’s trade deficit was $23 billion. However, due to the Chinese New Year effect, and a false trade base period last year, the volume of exports in the current account balance in 2014 is likely to be underestimated.

Taking into account all of these factors, it is clear that February’s exports and the current account balance are still weak. From the perspective of the fundamentals of international payments, the yuan exchange rate has been relatively close to equilibrium.

For these reasons, it is unlikely that yuan will continue to lose its value over time. Moreover, after the People’s Bank of China announced the expansion of yuan exchange rate volatility on March 15, the depreciation rate was expected to soar. However, the current rate is still modest, and a sharp depreciation of the currency exchange rate will not happen in China, as in some other emerging economies, because it is still within controllable means.

This is also because since the 2008 global financial crisis, short-term international capital inflows into China have been limited, while in countries such as Turkey, Mexico, and South Africa, net short-term capital inflows since the crisis have accounted for almost all of its foreign exchange reserves. In others countries such as India and Brazil it was nearly 50 percent. Though China’s capital account has limited access, it has a huge pile of foreign exchange reserves. This mitigates the possibility of sharp exchange rate depreciation in China. Devaluation of the yuan will also help alleviate pressure on China’s exports.

Since the second half of last year, most of the currencies in the emerging nations have depreciated against the US dollar. The yuan’s depreciation against the dollar by 3 percent does not provide a strong impetus to fuel further growth in exports. Therefore, enhancing the competitiveness of enterprises should be the main focus at this stage.

However, the depreciation of the yuan is an important change since the exchange rate reform of 2005. Some analysts believe the central bank pulled the trigger. Although it is controversial, it is undeniable that unilateral yuan appreciation is expected to smooth into a two-way volatility change over the years.

For the central bank, its monetary policy independence will garner more space. In this case, in order to maintain the stability of the yuan against the dollar (1 percent in the volatility range), it needs to intervene more actively in the foreign exchange market.

Specifically, it should release more yuan and absorb more dollars in the foreign exchange market. Although the central bank has been carrying out effective hedging operations, its costs are also rising rapidly. After further liberalization of yuan exchange rate, the monetary policy can be relaxed further.

As for foreign trade enterprises, the exchange rate risks will not necessarily increase in the long term. The reason is simple: because 70 percent of China’s exports cater to economies outside the United States. In the past, in order to maintain the stability of the yuan against the US dollar, there was always a compromise on the yuan’s stability vis -a-vis the euro, Japanese yen, South Korean won and other currencies. In the next few years, the quantitative easing in the US will further weaken the yuan’s dependence on the dollar and help stabilize the yuan’s effective exchange rate.

In the international financial markets the yuan will have several new opportunities.

Countries that have close economic and trade relations with China will soon take into consideration the yuan fluctuations in their exchange rate formulation mechanism.

The currency appreciation will also promote the offshore, onshore yuan exchange rate forward market, and the development of derivatives markets.