25th February 2014
Financial markets have been buzzing with contradictory stories about why the Yuan has recently fallen in value ever so slightly – but breaking a long-term trend towards managed appreciation. For some, it’s of minor consequence, as the People’s Bank of China (PBC) tries to do what China’s leaders have promised, namely to make prices, including of China’s currency, more market-oriented. The +/- 1% trading band is supposed to be widened in any event to +/-2% at some point. A two-way market in Yuan, especially now that it doesn’t appear to be grossly mis-valued, is only to be expected eventually. Others have suggested that the PBC has become concerned about the Yuan carry trade, that is borrowing in US$ and on-lending in China at much higher interest rates in the domestic economy. And over there in a murky and dangerous corner, but not one to be dismissed out of hand, is the possibility that China is now not unhappy to tolerate depreciation as a matter of policy.
Last year, the Yuan appreciated by 3% against the US$ – modest, but exceptional when most major emerging market currencies turned down against the US$. In real, as opposed to nominal terms, the Yuan has risen steadily for the past eight years, by around 40%, and roughly a quarter of this happened in 2013. The impact has certainly been felt in Chinese export performance, which has been lacklustre, but I don’t think there’s anything here that, alone, would trigger a policy change by the Chinese authorities or the PBC. And in fact, China’s current account surplus is solid and sticky, if a lot smaller than it used to be, at about 2-3% of GDP. This is as it should be, because of the continuing surplus of domestic savings over investment. Bear in mind also that China remains a net recipient of FDI, and financial capital has been flooding into China because of the widening interest rate differential between local and foreign interest rates. Even if the exchange rate did decline and result in losses or stabilisation needs, China has $3.8 trillion of reserves that stand behind them. Plus, how could China’s aspirations to internationalise the Yuan be credible if it were thought to following a policy of devaluation?
But this doesn’t mean a weaker Yuan is an impossibility.
It’s entirely plausible, the above notwithstanding, that China is ready to inject a bit of uncertainty into the Yuan market. A strong reason in support of this argument concerns the surge in foreign lending to the onshore market in China, aka the carry trade, which is profitable a) on funding and lending cost comparisons and b) if the Yuan appreciates. UBS China’s economist Tao Wang estimates that net non-FDI capital inflows – call them ‘hot money’ – amounted to more than $150 billion in 2013, compared with a total rise in foreign exchange reserves of $433 billion. These flows will have originated in the form of over-invoicing of exports, which the authorities have since clamped down on, and foreign borrowing by Chinese SOEs, corporations and banks. BIS data on claims by foreign banks, moreover, showed an increase of $243 billion to a level of $806 billion, with HK and Singapore banks in pole position, especially the former. Bear in mind that foreign claims on China were a mere $200 billion in 2008 and then $500 billion in 2010, so the rate of increase has been astounding.
It wouldn’t be surprising, therefore, if the PBC were trying to discourage expectations about a one-way street in the Yuan so as to take a bit of the sting out of foreign exchange-related financial capital inflows. So far, so good. But what if capital started to leave China, for example if foreigners thought the fx game was up? It could easily lead to an undesired tightening of liquidity conditions in China. And if foreign banks pulled back a bit and the Yuan were expected to fall further than domestic borrowers expected, the latter might find funding sources drying up and higher repayment and debt servicing bills. Property developers might be especially exposed, and there have been anecdotal but important reports about ‘difficulties’. Developers in Hangzhou, the capital of the eastern province of Zhejiang, and in Chanzhou further north, have been reported as offering price discounts of 15-20% on properties signalling both an inventory bulge that is proving hard to shift, as well as financial difficulties (see Steep Discounts Prompt Fears Property Market Faces Dark Days at http://english.caixin.com/2014-02-25/100643057.html). It’s not clear how widespread this is, but it isn’t unique.
So, even a relatively benign carry trade interpretation of the recent change in the Yuan’s behaviour is not without risk, even if it seems mostly to be a shot across the bows. But there is a more worrisome scenario that is worth bearing in mind. We know China’s financial system has been wobbling a bit. Trust loans, which form about 10% of the so-called shadow banking system have been the subject of considerable scrutiny as the assets they’ve backed, mostly in resource companies, have proven to be suspect. Default risks have, for the most part, been avoided by last minute bail-outs. But it is clear from both macroeconomic and credit growth and intensity trends, as well as from lending and payment data from banks, local government financing vehicles and other shadow finance entities that system deleveraging isn’t working out the way that the authorities may have hoped. Tighter financial conditions, for example, when market rates remain elevated give rise to economic pain. Loosening them again only offers temporary relief – and negates the entire economic strategy of financial innovation, economic reform, and building strength in markets by allowing markets to perform.
So there’s a chance, not huge right now, but a chance that the ‘option’ of turning a blind eye to a cheaper Yuan could become more attractive if it looked as though it would help to soften the deleveraging and economic adjustments that China has to go through sooner or later. We have had significant slowdowns in economic growth at the start of both 2012 and 2013. Sequential GDP growth slowed on both occasions to about 6% annualised, and the authorities responded by cranking up credit and investment. Surely this option now looks either unrealistic or dangerous?
Either way, if investment growth were to falter and domestic debt servicing capacity were to become problematic, the temptation to rely on a weaker Yuan to give exports a shot in the arm and seek out a devaluation path to economic growth might be taken. This would represent a serious development for China’s relations with the US, and put China right at the centre of attention of currency and deflation wars globally, and trade wars in Asia. Depreciation as policy would raise the risk of accentuated credit problems inside China, and capital flight from China. For all these reasons, we should still assume that China’s leaders will be careful to avoid the risk that their so far modest adjustments to the Yuan will be misinterpreted.
Then again, China is in the throes of huge structural and policy changes. At the very least, the sequencing issues in financial innovation, capital account liberalisation and economic reform – to the extent that these do not require political reform, which remains ‘verboten’ – are fraught with the risks of miscalculation and unintended consequences. Be warned.