The Chinese yuan countdown is on
- Currency stability is a prerequisite for China's economic transition
- Defending the yuan is prohibitively expensive – China cannot beat the market
- Progressive devaluation managed by PBoC is the most probable scenario for 2016
- Remember that the country is on the capitalism learning curve
- Exchange rates will inevitably be a key discussion point at Shanghai G20
- China has moved from being a net importer to a net exporter of capital
The undervalued Chinese yuan is nothing but a bad memory. In the context of competitive devaluations throughout the world, the yuan is now significantly overvalued compared to its main counterparts, primarily the dollar and the euro.
If it is to pull off its economic transition, China needs a stable currency, hence its repeated interventions on the exchange markets over the past few months. Over the last year $513 billion was drawn from the foreign exchange reserves without stemming any of the downwards market pressures on the yuan. Over the period is actually lost 5% against the US dollar. This is a significant depreciation for a currency that is used to fluctuating between narrower markers. By way of comparison, the euro, which floats freely on the market, lost almost 6% of its value against the US dollar last year.
The increasingly credible assumption of a devaluation before this summer:
- The progressive devaluation managed by the People's Bank of China
- Continued defence of the currency on the markets
- New Plaza-type Accord
The progressive devaluation managed by the PBoC is the most probable scenario for 2016. This will not interfere with the process of internationalising the yuan, quite the reverse, since it would make it possible to have an exchange rate that is more in line with Chinese fundamentals. The successive devaluations of last August (1.9% on 11 August, 1.6% on 12 August and 1.1% on 13 August) sent an important signal to the market which will therefore not be taken by complete surprise the next time should China repeat the operation.
If the yuan is not devalued, the PBoC could be forced to continue to defend the yuan on the markets. This is the counterproductive scenario. The interventions on the forex markets come at a cost that is increasingly prohibitive, given their ineffectiveness in stabilising the yuan. China cannot beat the market. At the current path (close to 100 billion dollars per month), the currency reserves could reach the minimum threshold of 2,800 billion dollars recommended by the IMF by the end of June.
A new Plaza Accord. This is the dream scenario for economists, but certainly the least likely in the medium term, given the lack of monetary policy coordination between developed and emerging countries. Starting from the premise that exchange rate volatility is too high and competitive devaluations that are not signed off at the global level have recessionary effects on economic activity, new Plaza accords could be signed under the auspices of the G20. These would aim to counter the major problems of the world economy: high exchange rate volatility, overvaluation of the yuan and the strength of the American dollar which heightens the risk of recession due to the debt explosion of market players in USD since 2008.
The thorny problem of capital outflows:
It would not be a good idea to implement the capital controls alluded to, since this would send a very negative message to foreign investors at the worst possible time. In addition, past experience shows that gaps can always be found in such measures in order to transit capital out of the country through indirect means, such as via Hong Kong, in China's case. For true effectiveness, strict controls are required which would result in the economy being completely stifled. This makes absolutely no sense in this case. China will have no other choice in the years to come, but to offer liberalisation guarantees to foreigners for the domestic capital market and strengthen its financial regulations, which are still very inadequate.
This long process does not exclude new significant corrections on the Chinese stock market or even business bankruptcies that will result in reducing the moral hazard. Nevertheless, what is certain is that a stable exchange for the yuan after devaluation could help reassure market players. This is after all, the simplest and quickest way to proceed. China does not have any other credible, effective levers to restore balance to its economy in the short-term.
Christopher Dembik is an economist with Saxo Bank in Paris