China’s biggest challenge for 2016 may turn out to be one of the tools that helped enable its rapid rise as an export powerhouse: its currency.
This year, Beijing scored a diplomatic coup when the International Monetary Fund integrated the renminbi, or yuan, into the basket of elite global currencies that it uses to track its members’ reserves. Now, Chinese officials will have to manage the mix of financial, economic and diplomatic tensions arising from their ambitions to see the renminbi in wide use — at precisely the moment when those tensions are higher than ever — and prove themselves worthy of the honor.
Stephen Jen, a partner at SLJ Macro Partners in London, compared China’s current challenge to the goal articulated by Chinese leader Deng Xiaoping in the late 1970s: to promote economic development through foreign trade and investment. However difficult that was, the government could rely on tangible benchmarks, such as industrial production and raw materials that the state could reliably influence.
“Financial sector development requires critical ‘soft power’ that many emerging market economies don’t yet have, including the rule of law, a transparent corporate culture and effective regulation and supervision that help nurture a culture of ‘investment’ rather than ‘speculation,’” Jen said.
Nevertheless, 2016 will be a year when, ready or not, Chinese officials will have to ensure that a modest decline doesn’t become a full-out stampede by speculators and wealthy Chinese out of the renminbi, and that the country stays on a path of economic reform amid much lower expectations for growth than even a year ago. Lurking over the issue is potential trade friction with the United States, which has long complained that China keeps its currency weak to drive its export machine.
The People’s Central Bank of China, the renminbi’s issuer, sets a rate each day for the currency, which is then permitted to trade in a range 2 percent above or below the target. How it moves lets the bank measure the mood of currency markets, one of many factors it might consider when setting the next day’s rate.
As the currency’s issuer, the central bank can sell renminbi if it strengthens too much, or sell dollars from its massive stash — about $3.4 trillion — if the opposite is the case. In a fully liberalized market, the exchange rate itself does the work, deterring sales of a country’s currency when it weakens, or discouraging inflows when the currency strengthens.
In September 2010, the rate was about 6.8 to the dollar. Then began a slow, steady rise of the renminbi to almost 6 — an appreciation of 11 percent — by January 2014. In the last two years, the Chinese currency has sunk back down to near 6.6 to the dollar, and most of that depreciation has come since China's surprise devaluation in August. Another 10 percent devaluation in 2016, and a similar amount the following year, seem plausible, Jen said.
A mix of factors are at work. China's economic growth target of 6.5 percent for 2016-2020 implies less need for outside investment. The Federal Reserve’s new — but still slow — plan to raise interest rates will draw money into dollars, and out of emerging market currencies. And China will have to spend billions of its dollars for projects under the aegis of its “One Belt, One Road” initiative to knit together Asia’s transportation infrastructure.
Janet Henry, chief global economist at HSBC, said China’s political room for maneuver is limited, since inclusion of the renminbi in the IMF’s elite group means the leadership will need to demonstrate competent economic stewardship even as the pressure is on to deliver fast growth. That works against a fast devaluation that would fire up exports.
“Even more so now that China is to be admitted into the [IMF’s basket] in late 2016, we think it is unlikely that China would seek to devalue its way out,” she wrote.
It doesn’t take much imagination to see how the calm, considered plan could fall apart if Chinese growth disappoints, and Chinese officials seek “a little bit of stimulus” via a weaker currency to calm worries of higher unemployment and civil unrest, said Erik Nielsen, chief economist at UniCredit.
“Now imagine the saber-rattling in Washington on the back of a renminbi depreciation against the dollar,” Nielsen said.
It could all happen quickly, with more impact on American and European economies than in years past.
Compared with a decade ago, the breadth of China's imports and exports is far, far larger and includes products that will respond quickly to price if the renminbi declines sharply. If markets grow convinced that the devaluation will be sustained, businesses will react by reorienting supply chains in favor of Chinese vendors, making the trend harder to reverse.
“There are more products, and more that are price-sensitive,” said Gary Hufbauer, an economist at the Peterson Institute for International Economics.
Most economists regard the renminbi as overvalued, given that the rate of inflation is falling in China and a long boom in business investment is tapering off, so some depreciation is natural.
The harder pressure to manage may come from Chinese companies and citizens who are desperate to diversify their own holdings into currencies beyond their own, but hampered by various government-imposed controls. Jen estimated two years ago that as much as $3 trillion would seek to exit the country, if it could, and that $500 billion already got out, especially as the Chinese stock market tanked this summer.
“If the problem isn’t managed properly, you’ll get a snowball effect. And it’s not going to be easy. It has to do with psychology,” Jen said.
China has already been selling dollars to ensure that the outflows don’t drive the currency rapidly downward. Its reserves fell by $87 billion to $3.43 trillion in November, the lowest level since February 2013. Eighteen months ago, China husbanded nearly $4 trillion in forex reserves.
The greatest incentive that the Chinese have to keep the depreciation of the yuan measured and orderly is a long-term one.
Over the past decade, economists have plowed deeper into the question of the “middle-income trap,” the vexation of countries that achieve a measure of prosperity without breaking into the club of high-income nations. One way to ensure that outcome would be to protect industries that lose competitiveness with a weaker currency, an approach that was taken by countries such as Greece and Italy before the introduction of the euro.
The contrast is Germany, whose central bank never protected its exporters from the pressures of a strong currency. German industry responded by going upmarket and offshoring its lower-value manufacturing operations.
“The Chinese don’t believe in big devaluations,” said Jen. “They believe China cannot continue to incentivize the industrial sector to stay in low-value-added activities by keeping a weak currency. They have a Germanic view of life.”