21 February 2019
Grim economic and trade data could prompt China to devalue the renminbi further in the coming months, according to some observers. Photo: Bloomberg
Grim economic and trade data could prompt China to devalue the renminbi further in the coming months, according to some observers. Photo: Bloomberg

Why Beijing could allow the RMB to slide further

The abrupt devaluation of the Chinese currency has confused market participants.

Why did the central bank let the renminbi depreciate suddenly? Is there any other reason for the move apart from improving the daily fixing regime? Will it be a prelude to further depreciation or is it just one-off? How about further downside of the redback and how will Beijing react?

These are some of the questions passing through people’s minds. 

I had predicted in a previous article in July that the central government might consider sharp devaluation of the Chinese currency. The prediction has come true in less than a month. The daily fixing rate was cut nearly 2 percent on Tuesday before further downward adjustment the next day.

Authorities explained the move by saying that the real effective exchange rate of the renminbi has been overly strong relative to other currencies, and that it has deviated from market expectation.

However, some believe the move is aimed at fixing the long-time discrepancy between daily fixing and spot prices. Nevertheless, the recent adjustment is yet far from resolving that issue.

It won’t be a one-off adjustment, and there is further room for Beijing to devalue the currency, given worsening economic growth picture. Weakening currency is a natural way to boost exports.

Following China’s renminbi moves, both US and European markets have dropped, while several Asian currencies have also fallen in value. Meanwhile, gold price has risen due to rising safe-haven demand.

Washington warned that Beijing has failed to deliver its promise for carrying out foreign exchange reform and that its monetary policy has gone backward.

All these market reactions indicate that the market has seemingly priced in the risk of further devaluation of the Chinese currency. The renminbi devaluation could trigger a new round of “currency war”.

The renminbi still has no less than 7 percent devaluation if the currency is to be in line with the JPMorgan Asia Currency Index (ADXY). However, Beijing may have other considerations in any decision on whether to allow such massive devaluation. An upcoming meeting between President Xi Jinping and US President Barack Obama will offer more clues.

The renminbi devaluation and the market rescue measures are like a double-edged sword, which could bring negative economic implications.

The weaker currency will accelerate capital outflow. Global capital has been fleeing from emerging markets after the US Federal Reserve began winding up QE in late 2014. Capital flight has speeded up in China given gloomy economic outlook.

Foreign funds have been flowing out of China since mid-2014, as indicated by the foreign exchange reserve data. As of the end of July, as much as US$859 billion has flown out of the country over the last 12 months. And if the Chinese central bank further weakens the currency, capital outflow will gather more momentum.

Beijing has been focused on stemming the stock market slide, and hence unveiled various market rescue measures. It remains to be seen how these measures will affect domestic consumption and economy. However, the move already has created a “crowding out” effect.

Aggregate financing slumped to 718.8 billion yuan in July from 1.86 trillion yuan originally reported for June, while new yuan loans have soared to 1.48 trillion yuan.

That was due primarily to market rescue effort. Loans to financial institutions reached 891 billion yuan last month, which has indirectly tightened market liquidity.

I’ve noted last year that speculation on renminbi appreciation through financial derivatives is quite rampant on the mainland. It’s difficult to estimate the actual size of outstanding position of these contracts 17 months later. Some speculators could suffer huge losses.

The redback has been fairly stable over the past year, and I believe there are still many valid contracts, as most of the contracts are valid for 24 months. Now, the sharp devaluation of the renminbi is set to exert a lot of pressure.

China’s moves this week mark the first time that Beijing has allowed deep devaluation of its currency since the launch of foreign exchange reform. The development suggests that the nation’s economic woes are extremely serious.

This article appeared in the Hong Kong Economic Journal on Aug. 13.

Translation by Julie Zhu

[Chinese version中文版]

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Hong Kong Economic Journal chief economist and strategist

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