Renminbi Case Study

...

an increase from 29% and 22% over the past 10 years, having current account surpluses, coupled with low inflation and sufficient forex reserves, allows them to tolerate the yuan’s trend of depreciation as the CNY/KRW and CNY/TWD would not depreciate materially, hence limiting negative impact on their exports.

Philippines

With its sufficient forex reserves, strong current account surplus, and limited trade linkages with China (17% of its exports), Philippines stand to benefit from the yuan’s devaluation as they continue to be a net importer of Chinese commodities.

The Present: China’s Direction

Looking back to 2015 when China moved from monetary policy to fiscal policy as part of its stimulus program strategy, the fiscal stimulus program was intended to put a floor under the nation’s slowdown. To make this happen, China funded construction projects by selling ‘special’ financial bonds.

Firstly, what made these bonds ‘special’ was its supply – the quota for China’s local government bond sales increased three-fold from RMB 1.5 trillion to RMB 3.5 trillion. This increase was intended to push back some debts at lower interest rates – lowering the cost of money. However, the fundamental difference with the Chinese adaptation and other QE policies is that PBC pumped funds into the economy through its state lenders instead of being directly involved like other central banks.

Although local governments have been increasing its huge debts, economists broadly welcomed the move. The space for monetary policy expansion is constrained by the rapid increase in leverage over the past few years. Therefore, these economists have long argued that it makes sense to rely more on proper (bond-financed) fiscal policy to support growth.

At the turn of 2015, the prospect of a major devaluation in the yuan still hung overhead. In early 2016, Chinese policymakers worked hard to dispel worries about the weakening RMB at the G20’s Finance Ministers and Central Bank Governors Meeting in Shanghai: PBC announced that the persistent depreciations were under control as the government had tightened monetary policy through open market operations, not engage in competitive currency devaluation, and that structural reforms will be implemented decisively.

However, since that G20 summit meeting, CNY/USD fell for its fifth straight day to 0.1% against the greenback. Moreover, the Shanghai Composite Index (SCI) dropped to its lowest level in more than a year – the SCI has been commonly used as a benchmark for the trajectory of the RMB. One reason for the yuan’s downward trend has been because investors are getting more concerned for an economy that is slowing down faster than initially expected, coupled with several changes to China’s exchange rate policy and declining foreign reserves.

In the 3Q Monetary Policy Implementation report, PBC announced that they will prevent further economic and financial risks by paying extra attention to curbing asset price bubbles. With this as the focus, economists expect to see continued implementations of tighter monetary policy than in early 2016. Again, as a response to rising borrowing costs, China showed inconsistency as PBC injected a net of RMB 95.5 billion and RMB 595 billion in liquidity, through reverse repos, back into the economy in the 3rd and 4th week of October 2016 respectively (Daily FX, 2016).

The Future: 2 Scenarios

With the Chinese government’s flexibility and willingness to ensure the renminbi stays competitive globally, we now look at two future scenarios on how the Chinese economy and the value of the renminbi could develop over the next 12 to 36 months.

China’s Struggles, U.S. Boom

We see this as the most likely development (and also prescribed by many economists). In principle, several developments would lead to a continuing depreciation of the renminbi. Firstly, China’s economic growth has been slowing, and for foreign investors, it is still unclear by how much as reported growth figures are subjected to massive manipulations: officials of the Potemkin province admitted that it had inflated revenue figures by up to 20% (Economist, 2017). As its growth continues to stutter and forecasted targets become increasingly difficult to hit, investors’ confidence might wane, resulting in their investments being pulled out.

In this environment, China’s high debt level (over 250% of GDP) might just be the stimulant for the next GFC due to highly indebted Chinese companies not being able to service their debts because of lowered demand. At the same time, the U.S. economic growth is expected to accelerate due to increased fiscal spending (infrastructure investments) and expected tax cuts. This accelerated growth will result in a higher inflation rate, and the Fed will most likely raise interest rates further and faster (increasing the attractiveness of USD and U.S. assets as compared to the renminbi – further devaluating the Chinese currency) to tackle the inflation problem.

As with a ‘perfect storm’, these two developments might compound the acceleration further as a pull-out by foreign investors will lead to lower growth prospects which in turn will lead to even higher capital flight from China, resulting in a positive feedback loop. The Chinese government will then try to enforce capital controls to keep the money in the country or to strengthen its renminbi by selling more of its already depleting foreign reserves. However, in today’s financial systems, such capital controls will never be executed completely and will not be welcomed by the International Monetary Fund (IMF) (Reuters, 2016), especially when the renminbi was added to the Special Drawing Rights Basket in 2016 after China’s efforts to comply with the fund’s regulations of having open financial markets (IMF, 2016).

Lastly, the accelerated growth and appreciation of the USD are likely to lead to an increase in Chinese imports. Encouraged by the initial success of his policies, Trump may be encouraged to introduce controversial trade tariffs on Chinese imports which would lead to an even lower demand for Chinese products, the renminbi, and thus, leading to an even further devaluation of the Chinese yuan.

China’s Acceleration, U.S. Slowdown

While the previous scenario look bleak for the Chinese economy, we believe that the opposite can also happen: China will recover from its weak growth while the U.S. slides into a recession due to several different events and developments.

Fuelled