What happened to the Chinese Yuan and other currency developments
It is not surprising that, over the past six months, the Chinese Renminbi experienced a sharp depreciation by an overall 10 percent against the US dollar. However, the currency decline entered in a crucial phase when, at the beginning of last week, on Tuesday October 30th, the 10-year low was hit, taking the Chinese Yuan very close to 7 units per dollar. This value is not per se particularly significant, but it represents a psychological threshold for traders and analysts, and the reason is that the exchange rate has always maintained below this value since the financial crisis in 2008. Since then, the Chinese currency had only once got as close to 7 as it did last week and it happened at the end of 2016. In this period Donald Trump, during his presidential election campaign, firmly accused China of manipulating its exchange rate in order to boost exports and causing the US trade deficit with China.
There are many reasons to explain why the Renminbi went under pressure again, during the past couple of days. First of all, this year China registered a 6.5% GDP growth rate in Q3, which is the weakest since the global financial crisis, confirming the downward trend of the previous quarters. If on one side China is slowing down, on the other side the US is growing faster than expected: Q2 and Q3 growth rates of 4.2% and 3.5% respectively, beating expectations, and confirming a significant acceleration with respect to Q1. In this framework, the Federal Reserve is constantly raising the interest rates according to a path of monetary tightening. These factors combined may well justify the acute depreciation experienced by the Yuan against the dollar during the last week.
Another aspect to take into consideration when dealing with the Yuan, is of course the trade war with the US president Donald Trump. The trade war is constantly putting Yuan under pressure in the sense that every devaluation exacerbates the relationship with the US. Since, as previously mentioned, Donald Trump believes that China is purposefully keeping the value of the Renminbi low in order to boost exports and sustain growth. However, a substantial Chinese intervention on the currency is unlikely to come. On the contrary, in fact, the markets seem to expect People’s Bank of China to keep relying on tighter capital controls in order to avoid a further depreciation of the currency caused by capital outflows. But this scenario is discouraged by the PBOC itself that affirmed, in its last financial stability report, that monetary stimulus will not be used to boost growth in China because “prudent monetary policy will remain neutral”.
Pressure on the Chinese Yuan attenuated on Thursday, after media reported progresses on US-China trade dispute. In particular, Donald Trump affirmed discussions were going on nicely with China, generating a recover in renminbi and Chinese stocks.
In order to better understand the reasons why President Donald Trump repeatedly claimed about Chinese competitive devaluations, it might be useful to look back at the recent Chinese monetary past. As shown by the graph below, before 1995 the Chinese currency was characterized by a floating exchange rate. In 1995, however, China decided to have a fixed peg with the US dollar that lasted until 2005. The main reason behind this choice was to accompany the structural reforms of the Chinese economy and its growing integration in the global supply chain. The Chinese authorities thought that a stable exchange rate with the dollar was crucial for economic development. In fact, a fixed peg to the dollar would remove currency risk and stimulate the development of Chinese exports and foreign direct investment into the country. Hence, between 1994 and 1995, the currency was considerably devalued from below 6 Yuan per dollar to around 8.7.
In this framework, at the beginning of 1995 the economic fundamentals where pushing the currency to appreciate relative to the dollar. In particular, under free capital mobility, it would have been difficult for Chinese authorities to resist the appreciation of the Yuan without lowering interest rates generating a substantial ease. In a fast-growing economy such as the Chinese one, all this would have led to high inflation rates. For this reason, Chinese authorities decided to close capital accounts in order to fight appreciation and defend the fixed peg to the dollar. According to the Mundell’s Trilemma, in fact, the only way to preserve monetary policy independence with a fixed peg is to eliminate free capital mobility by closing capital accounts. The success of the Chinese economy while pegged to the US dollar was undeniable. As a consequence of this policy, China accumulated trade surpluses with other countries mainly in the form of foreign exchange reserves at the central bank. This simple analysis of the macroeconomic policies adopted by China in these 10 years show two of the main recurring anti-China slogans of President Trump: competitive devaluation and trade surplus accumulation.
In 2005 China decided to abandon the fixed peg to the US dollar, registering a smooth exit: from 2005 to around 2014 China experienced a very gradual appreciation of the currency. Chinese authorities decided to let the currency appreciate because at the end of the peg the Renminbi was greatly undervalued. The fact that China preserved closed capital accounts after the end of the peg helped the country to have such a smooth exit from the peg. It was only in 2014 that China started opening the capital accounts going towards a free capital mobility. It is important to remark that, however, at the end of the peg the Yuan did not become a floating currency but remained a “managed currency”. In particular, the Chinese central bank sets a daily guiding point for the currency and this is a signal for the market of where it expects the Renminbi to go.
WRITTEN BY FRANCESCO ROMAGNOLI FOR BESA
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