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After the Bank of Japan, the long march of the RMB is over

6th November 2014

The BoJ’s decision to expand its balance sheet by buying government bonds at a rate of JPY80 trillion – that’s a rise in the size of the balance sheet from just under 60% to almost 80% of GDP – has preoccupied global markets this last week or so. The Yen dropped like a stone to a level last reached in 2007, a time when it was in the early stages of a rise from Y120 against the US dollar to almost Y75 at the end of 2011. We should assume that the BoJ is going to keep at it until it is satisfied that Japan has turned the corner on deflation and achieved its goal of sustainable 2% inflation, if indeed that’s possible. This will most probably mean further currency depreciation, perhaps to around Y130-140 against the US dollar, possibly even more.

This is going to have profound consequences for Asia in general, and for China and the Renminbi (RMB) in particular. The long march of the RMB upwards may be pretty much over, and we should prepare for the consequences of a (partial) reversal. Recall that after the decision to widen the daily fluctuation bands to 0.5% in 2005, the RMB-US dollar rate rose from 8.27 to 6.82 in 2008, where it was frozen for two years as the financial crisis unfolded. When it was allowed to move again, the RMB rose steadily to around 6.05 at the end of 2013, since when it has oscillated around 6.10-6.15. But, as suggested, the BoJ decision, which translates directly into a weaker Yen is likely to end up turning the trend in the RMB. Think, for starters, about a move towards 6.50 over the coming year or so.

At this stage, it certainly doesn’t look as though the Chinese government needs or wants to give its blessing to a formal policy of depreciation, which would go down like a lead balloon in Washington DC, all over Asia and not a few places beyond. It would also represent a self-inflicted wound, of course, given China’s substantial holdings of US dollar assets.

It’s not like the run-up to the Asian crisis in 1997 when a 50% fall in the Yen against the US dollar acted as the trigger for competitive devaluations, given the prevailing pegged exchange rate regimes in Asia against the US dollar, and the accumulation of large external and fiscal imbalances. Although the Yen has fallen by 50% since early 2013 from a heavily overvalued level, and by 15% since the subsequent correction, the trade-weighted values of most important Asian currencies have remained fairly stable – so far at least. As long as countries such as Korea, Taiwan and Singapore don’t follow the Yen down, China has little reason to do so either. But watch this space, because this is exactly what happened – or didn’t happen – in the mid-1990s, and as stated, it was the trigger for significant financial turbulence. If the Yen carries on falling, though, we should not expect Asia, and China, to stand there with arms folded: some matching depreciation, at least, against the US dollar is highly likely.

On the domestic side, Chinese tolerance of a weaker RMB in the light of a generic appreciation of the US dollar is also on the cards as an additional way of loosening monetary conditions in the face of a secular slowdown in residential property investment that is bringing GDP growth steadily lower. The PBC, as the agent of the government, does not want to indulge the economy in open-ended credit stimulus at a time when it is trying to wean it slowly off credit creation as a prop for growth.  But it has been trying to ease monetary conditions in recent months, keeping liquidity in the economy plentiful, making special lending facilities (pledged supplementary lending) available to, and cutting reserve requirements for, major commercial banks, and lowering repurchase rates. Meanwhile, a wide range of restrictions on home mortgages has been lifted, and banks are being urged to lend at preferential rates.

The problem is that China doesn’t really want to lower interest rates in a blanket sense formally, since it runs the risk of sending a signal about monetary reflation that may be misinterpreted. What it wants to do is reallocate credit from property, land developers and SOEs to small and medium-sized enterprises, which are having to pay penal rates for access to credit, if they can access it at all. But this strategy requires more complicated policy initiatives to reform bank credit approval and underwriting procedures, and to allow SMEs improved access to the formal banking sector rather than being driven to the shadow banking sector, where deposit rates and lending charges are higher. But financial reform, and the delicate issue of financial liberalisation, are a tough ask at the current time and might well carry economic costs and risks that the authorities may be unwilling to bear. The short-circuit, therefore, is likely to take a more traditional, and far less effective, form: lower official interest rates, and a weaker RMB.

A change of course for the RMB might have happened anyway, as a result of its having reached ‘fair value’, and in the wake of a sustained slowing in economic growth. But the BoJ has set the cat among the pigeons, inviting another round of currency wars in Asia and beyond in 2015. Unlike the Asian crisis, when China remained aloof from the fray, it is likely to be centre-stage this time. Investors will watch closely, but all of us should as well. We all hail China’s significance as the world’s biggest economy and exporter, but along with that goes a significance for regional and global economic and financial stability. If RMB depreciation was miscommunicated or misunderstood, let alone large, that’s exactly what could happen.