US President-elect Donald Trump believes China artificially manipulates its currency to gain an unfair export advantage. He said as much during the presidential debates, after winning the election, via Twitter and on just about every other occasion possible.
To remedy an allegedly unfair trade advantage, the President-elect promises a 45% export tariff on Chinese goods. That Mr. Trump is patently wrong about currency devaluation is well-known. Less understood perhaps is the importance of reversing recent losses in renminbi value and the many benefits to China of a strong and stable currency.
Rapid Chinese economic growth in the mid-90s was unprecedented. It was based largely on market reforms, foreign direct investment and competitive exports. Underpinning all this was a stable yuan pegged to the US dollar; simultaneously anchoring a growing economy whilst safeguarding investor confidence. But economic growth in China, and for that matter elsewhere in the developing world is unlikely to be fueled endlessly by exports.
For different reasons, major export destinations like the European Union and the United States are expected to register lower demand for Chinese goods. Europe continues to battle the twin specters of political uncertainty and declining economic growth while American markets appear set for a period of protectionist policies under Mr. Trump. To be clear, the road to economic growth for China runs not only through cheap exports but rather robust domestic consumption.
Notwithstanding the tremendous potential of Chinese consumers—Alibaba Group alone reported US$17.8 billion in sales on Singles Day this year—domestic consumption in China accounts for less than 40% of GDP. Compared to a range of approximately 60-65% in developed Western nations, this is remarkably low for a country with stable consumer confidence.
Effectively, though they remain optimistic about the economy, Chinese consumers are unable to spend as freely as they need to on entertainment, automobiles, high end electronics, etc. If and when domestic spending increases, demand for manufactured goods and services is expected to rise as is manufacturing capacity. Increased manufacturing spurs hiring which in turn boosts the household income level. Incidentally, activity of this kind and in this sequence is the very definition of a vibrant economy. Crucially, it is one that is both stable and free of unpredictable overseas market and political trends.
Elementary though it may sound, none of this is possible until the RMB gains in strength. But herein lies the rub. The RMB has weathered a year of depreciation pressures including a fast growing real estate bubble and disappointing economic growth. Coinciding with recent efforts to liberalize the currency, the outbound flow of capital has been as large as it has been consistent. Companies have shifted RMB directly across borders, often under the guise of overseas mergers. For some, it was a tactical decision to invest in a strengthening US economy and greenback. For others—mostly individual investors—it was an attempt to secure the value of their holdings. The unintended effect has been a further devaluation of the currency.
Not unlike efforts to stanch losses during turbulence in the stock market last year, government authorities have moved quickly and decisively. The PBoC has conducted reverse repos to dry up liquidity and is expected to enforce new regulations restricting overseas lending and investments. Additionally, the Central Bank has sold dollar holdings from its foreign exchange reserves to support the exchange rate.
The campaign appears to have worked—but only to an extent. While it is no longer hemorrhaging value, the yuan remains at a low of 6.9 against the dollar. Hong Kong-based yuan and bond markets are in decline even as the currency continues to lose appeal for international trade transactions.
In the weeks and months ahead, additional pressure on the Chinese currency is expected. A resurgent dollar is only expected to get stronger, the direct consequence of a 25 basis-point increase to the Federal Funds Rate and the expectation of up to three additional hikes over the next year. Further gains are anticipated next January when Mr. Trump assumes the Presidency. His promise of loose fiscal policy and a commitment to massive infrastructure spending is proving a boon for American equities and by extension the greenback.
Not all downward pressure emanates from the US. Restrictions limiting Chinese investors to no more than $50,000 worth of overseas fund transfers per annum expire in the New Year. Because fears persist of further devaluation, analysts anticipate an additional flight of funds.
What then is the remedy? As it turns out, the solution to this seemingly intractable problem is fairly straightforward. It involves a combination of additional interventions in the forex market, higher interest rates, and tighter fiscal discipline.
For the last two years China’s forex reserves have fallen steadily and are at their lowest levels since March 2011. That being the case, a total of $3.052 trillion remains the largest holding in the world today. Time now to put it to use. The PBoC has sold of some of its dollar reserves to support the Yuan, but more of the same is needed.
Similarly, low interest rates intended to benefit the manufacturing sector must now be reversed. Not just because factory gate inflation is on the rise but because chronically low rates will continue to spur the flight of capital. Only when the yuan becomes more attractive for foreign and domestic investors will the currency settle on a sustainable and fair value.
Finally, local authorities throughout the mainland must embrace fiscal discipline. Like high interest rates, this measure can also be relied on to drain excess liquidity from the market. More importantly, it will have the ancillary benefit of cushioning some of the asset bubbles that have developed as a result of cheap credit.
We are only two years removed from the year 2014 and in retrospect, it was a seminal point for the yuan. The Chinese economy had overtaken that of the United States in terms of purchasing power parity. After the dollar, yuan was the legal tender most in demand for international trade finance. It almost felt like the dollar, the preeminent currency of its time had a challenger. Despite the current value of the yuan, it still might. If remedial measures are taken and recent losses recouped, there is every chance the yuan may yet emerge as a “co-eminent” currency.