24 May 2019
Most of the bearish views about a steep fall in the renminbi exchange rate against the US dollar are based on a distorted understanding of the Chinese currency. Photo: HKEJ
Most of the bearish views about a steep fall in the renminbi exchange rate against the US dollar are based on a distorted understanding of the Chinese currency. Photo: HKEJ

Why renminbi bears may be wrong

Some daring analysts are forecasting a more than 8 percent decline in the renminbi-US dollar exchange rate (to more than 6.60 yuan per US dollar from today’s 6.11 yuan) by the end of 2015.

However, most of the bearish views are based on a distorted understanding of the currency.

If it were not for the People’s Bank of China’s intervention earlier this year, which forced a 3.4 percent devaluation of the renminbi against the US dollar from its peak (to squash one-way bet on renminbi appreciation), it would still be on track to appreciate by 1.5 percent year on year this year as I had expected.

Since the intervention, the renminbi has appreciated by more than 2 percent.

The medium-term fundamentals, in essence the sum of China’s current account balance and net long-term capital flows, suggest that the renminbi’s underlying appreciation trend remains.

Notably, as I started arguing two years ago and despite it being contrary to market expectations of a decline, the current account surplus has improved.

Many analysts have concluded that the US$105 billion drop in China’s foreign exchange reserves in the third quarter, the first decline since the second quarter of 2012, was due to large capital outflows.

However, there is no evidence to support such bearish views.

Firstly, allowing for exchange rate movements among the major currencies, China’s foreign exchange reserves might have remained unchanged in the third quarter.

China’s central bank reports its foreign exchange reserves at face value and in US dollar terms. So even if it makes no changes to the foreign exchange portfolio composition, if the foreign exchange value of the non-US dollar portion falls, the headline value of the reserves will show a decline.

This can be misinterpreted as a change in the actual foreign exchange holding, affecting capital outflows and eventually putting downward pressure on the renminbi.

Research shows that a large and growing share of China’s foreign exchange reserves has been allocated to non-US dollar currencies, notably the euro, Japanese yen and pound sterling, which together account for an estimated one-third of the total.

The sharp depreciation of the euro, yen and pound sterling against the US dollar (8.5 percent, 8.3 percent and 5.2 percent, respectively) thus markedly reduced the value of China’s foreign exchange reserves.

Granted, there have been hot money outflows from China recently, but they have not been so large as to cause a sharp drop in the renminbi soon.

Renminbi bears have also argued that record-breaking US dollar borrowings by Chinese companies would force a sharp depreciation in the currency sooner or later.

Some have estimated that China’s corporate debt swelled to 124 percent of gross domestic product now from less than 100 percent just a few years ago, and that total US dollar debt had risen to US$907 billion in June 2014 from less than US$390 billion before US quantitative easing (QE) started.

Even if we don’t question the accuracy of these estimates, such debt level won’t be bad enough to trigger a sharp renminbi decline.

For example, the estimated US$907 billion total US dollar debt that Chinese companies are said to have raised since QE began in the US amounts to about 23 percent of China’s foreign exchange reserves.

Even assuming all this debt to be short-term, it is too small (with 4.3 times foreign exchange coverage) to have any material effects on the exchange rate.

Experience shows that countries with total debt-to-exports ratios above 200 percent eventually hit a financial crisis point.

China’s estimated US$907 billion foreign corporate debt is equivalent to only 75 percent of its total goods and services exports.

Empirical evidence also shows that when a country’s total interest payments-to-exports ratio passes 20 percent, its debt becomes unsustainable, and financial/currency crisis will ensue.

Even if we assume an average – and very aggressive – 10 percent interest rate on China’s US dollar debt, its interest-to-exports ratio would only be 8 percent.

The rapid increase in China’s corporate debt is indeed a concern but it is not yet so grave that it would cause a sell-off of the renminbi.

China is a US$9.4 trillion economy, with total credit estimated at about 230 percent of GDP, or US$22 trillion.

The estimated US dollar debt is about 4.2 percent of the total. This means that China’s debt is basically denominated in domestic currency, which (combined with its excessive foreign exchange coverage of debt servicing) reduces the odds both of a run on the renminbi and of a debt crisis.

The ultimate game changers to the renminbi’s direction would be deterioration in China’s external balances to an overall deficit, a rapid opening up of China’s capital account or a change in the central bank’s currency stance, or a combination of these drivers.

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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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