In July 2016, the yuan dropped to its lowest rate versus the dollar since 2010. What does this development mean, and what can we expect for the future, given Chinese ambitions to present the yuan as a strong and reliable international currency? In order to make any predictions, it is necessary to know what the authorities in Beijing will do to address the economy’s current problems.
If they choose business as usual, the yuan is likely to keep falling, as capital outflows continue and export performance sputters. The recent increase in regulation – a departure from the previous free-market attitude – will just make things worse. By contrast, if the authorities eventually see that the performance of the world economy will do little to solve their own domestic failures, then a program of serious reforms might see the light. This would increase exchange-rate volatility dramatically.
The international community breathed a sigh of relief when China’s growth forecast came out in March. Chinese authorities announced that gross domestic product would grow by 6.5 percent in 2016. That’s fairly good by Chinese standards, and a great performance by global standards – the World Bank sees worldwide GDP growth reaching no more than 2.4 percent (down from a forecast of 2.9 percent in January).
But will the Chinese forecast hold up? There are plenty of reasons to question whether it will, especially the yuan’s recent slide to unexpected lows against the dollar. This development could be a warning of trouble to come.
As GIS has stated before, the Chinese economy is not headed for imminent collapse. However, it is also not in good shape, and the drop in the value of the yuan reflects the economy’s structural weaknesses. These are deficiencies that Beijing has failed to address in a satisfactory manner.
Strengths and weaknesses
At the beginning of July, the yuan hit 6.68 against the dollar, a nearly six-year low. There are three reasons for the slump. The first is the dollar’s strength. Considering the effective exchange rate of the yuan (the effective exchange rate compares one currency with a basket of currencies, rather than with one other single currency), the slide is less profound.
In fact, between 2010 and 2015 the yuan’s effective exchange rate appreciated by 26 percent, and is currently only about two percentage points below its maximum. The yuan is therefore actually stronger than meets the eye. If the Chinese economy comes under pressure in the next few months, one could expect a much more significant downward movement.
Secondly, the yuan suffers from the weakness of the Chinese export sector. After a 1.8 percent annualized drop in April, the value of Chinese exports fell by another 4.1 percent in May. This data is not very reliable and subject to statistical anomalies (for example, it appears that many exporting companies have recently moved offshore – to Hong Kong). Moreover, the Chinese trade surplus remains substantial.
Nevertheless, the foreign trade data is a source of worry to those who had counted on the export sector to prop up heavily indebted companies and economic expansion. Slow growth in the West and increased competition in key industries such as cheap apparel and consumer electronics do not help.
It would not be a surprise if the authorities in Beijing had second thoughts about moving toward a free-floating yuan and instead reverted to managing the exchange rate more aggressively. The goal would be to help struggling exporters by reversing, at least partially, the strong appreciation of the nominal exchange rate that has taken place over the past few years.
A third source of worry is the ongoing outflow of capital, which in May seems to have gained momentum (reaching about $28 billion for the month, according to the official data). Once again, this is not much compared with China’s official reserves of about $3.2 trillion. However, it is not a trifling sum, especially considering that Beijing has recently introduced new restrictions in order to stem the outflow.
It is common knowledge that Chinese leaders take great pride in having large foreign currency reserves, which enhance their economic and political clout both in the West (as buyers of government debt) and in poorer nations (as generous lenders).
The future of the yuan will be closely correlated with Beijing’s policy vision. There is no doubt that the Chinese economy is saddled with a number of problems. The banking and the construction industries remain fragile. Profitability is shrinking due to foreign competition and rising production costs, brought on by lagging in productivity growth after a rise in real wages.
These challenges are by no means new. Until now, the authorities have been kicking the can down the road by resorting to a mix of makeshift policies: a managed exchange rate, restrictions on capital movements, an expansionary monetary policy and preferential lending to troubled companies.
These measures are just buying time, but acute problems need to be fixed, and the price that China will have to pay to put its economy in order continues to increase. It has been estimated that debt servicing will soon absorb more than half of corporate profits, a situation that will encourage investors to shift their money abroad and will make it more and more expensive for firms in China to finance new investments.
What will happen then? Will bad loans be written off and turn an already shaky financial system into a heap of rubble? Or will the government persuade the banks to offer new loans to an ever larger number of limping companies?
Two scenarios are possible. In the first, policymakers in Beijing will realize that buying time by delaying reforms and backtracking on their commitment to a free-market economy will not be effective. In particular, they would see that the world economy is likely to grow at a slow pace for years to come, that Europe is stagnant and vulnerable to an institutional shake-up, and that several undeveloped economies are barely keeping their heads above water.
In such a scenario, Beijing would stop relying on the global economy to solve its own domestic bottlenecks, and would engage in serious, painful reforms. Should that happen, the yuan could rise or fall depending on the expected political repercussions.
The Chinese currency could strengthen as a consequence of the investment opportunities that a truly free-market economy would offer: within this framework we would witness less political interference, fewer resources devoted to propping up bad state-owned companies, and a judiciary less subservient to the political elites. The yuan would benefit from a reversal of the capital outflow and from the likely inflow of fresh investment from the rest of the world.
It is also possible, however, that the volatility implied by reforms leads to tensions and scares away many investors, at least temporarily. Massive capital outflows would follow and the yuan would weaken rapidly.
A second and more likely scenario would have Beijing continue the policies it has pursued recently – pretending to tackle structural problems by resorting to the very countercyclical tools (expansionary fiscal and monetary policies) whose limits have already become clear in many economies worldwide.
If this happens, the yuan will continue to depreciate. How much it weakens against other currencies will be dictated by how strongly the People’s Bank of China intervenes in the exchange rate market and on the stringency of controls that will be imposed to slow down capital outflows.
A soft landing for the yuan will do little to prevent an economic crash. China’s 6.5 percent GDP growth rate is no guarantee of stability. In this light, future movements of the yuan – both in terms of volatility and direction – might provide useful insight into what is really happening in Beijing’s hallways.
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