18 November 2018

Is this the dawn of the RMB’s big descent?

It’s become more volatile and fallen more than 1 percent against the US dollar in the last month but is China’s currency on the brink of a bigger depreciation trend? Not really.

This spell of yuan weakness is likely to be short-term and policy-induced. The central bank is trying to rein in excessive speculation on renminbi appreciation on the back of strong hot money inflows, as reflected in the record selling of US$76 billion by onshore banks on behalf of clients in January alone.

The RMB’s fundamentals still point to appreciation in the medium term as China’s total external surplus (the sum of current and capital account flows) is still big at 4.5 percent of GDP. But the market needs to get used to more volatility in RMB trading because China is opening up its capital account, albeit slowly.

Granted, China’s current account surplus has fallen in recent years. Under a closed capital account, a falling current account surplus erodes the RMB appreciation pressure and pushes it towards equilibrium. But things are not that simple. China’s current account surplus may grow again soon, reviving RMB undervaluation and putting Beijing in an awkward foreign exchange policy position.

The narrowing of China’s current account surplus over the past five years was arguably an elusive indicator for the correction of RMB undervaluation. The reason rests with commodity prices. China has turned from a net exporter of primary products and raw materials into a chronic net importer since the 1990s as a result of industrialization. Its raw materials trade deficit has grown from less than 1 percent of GDP in the early 1990s to over 6 percent.

This suggests that China’s shrinking current account surplus has more to do with the rise in commodity prices — which has dealt a negative terms-of-trade shock to its current account — than with a genuine change in China’s trade structure. Global commodity prices, as measured by the Commodities Research Bureau Index, started rising in 2002 and cutting into China’s current account surplus, peaking at 10.1 percent of GDP in 2007.

Commodity prices then started falling in 2011, and in the following two years China’s current account surplus headed up again. If this relationship holds, further weakness in commodity prices would push up China’s current account surplus through a positive terms-of-trade impact.

At the same time, there has not been any change in China’s trade structure that could have caused the decline in its current account surplus. Evidence shows that China’s trade surplus with its two largest trading partners, Europe and the United States, has continued to rise despite a fall in its overall trade surplus since 2008.

In other words, RMB appreciation over the years has not helped rebalance China’s trade structure towards more import growth than exports. So the sharp decline in the current account surplus (which is dominated by the trade surplus) since 2007 is not really indicative of the RMB approaching equilibrium.

The RMB will only depreciate on a sustained basis when China’s total external balances turn into a deficit, but there is no sign of this happening in the short term. Even if China’s exports and imports and net foreign direct investment flows were to grow at the same rates as in 2013, commodity price weakness could easily push up its current account surplus to over 3 percent of GDP through a positive terms-of-trade shock. But China’s exports may grow faster than in 2013 due to stabilizing global demand and its imports may grow more slowly under domestic structural reform pressures.

So the chances are high that China’s current account surplus might expand again, putting upward pressure on the RMB. International pressure for a revaluation of the yuan will mount but, there need not be a sharp rise in its exchange rate because, from a policy perspective, Beijing will only relax its control gradually.

From a market perspective, since China’s capital account is gradually opening up, there will be times when capital outflows will overwhelm capital inflows from the current account, resulting in temporary RMB depreciation — just as we have seen in recent weeks. In fact the RMB has had periodic depreciation since 2012.

And that’s why RMB volatility will likely rise alongside a widening current account surplus. Beijing should take this as an opportunity to expand the RMB trading band — which is set at +/-1 percent around the central bank’s daily fixing rate — to accommodate economic volatility and to fend off international pressure to revalue the RMB.

Rising RMB volatility also increases the foreign exchange risk. This should help RMB internationalization by prompting more foreign exporters and importers to use RMB for trade settlement as they seek to reduce foreign exchange risk.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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