China recorded the weakest GDP growth rate (6.9 percent year on year) since the global financial crisis for the third quarter of this year, fueling concerns about economic hard-landing and sending shock waves across the global economy.
News headlines are full of stories about Chinese capital outflows and massive losses of foreign reserves following the People’s Bank of China’s (PBoC) market intervention to stem such outflows and stabilize the renminbi.
Think of any bad news these days and one can relate almost all of them to China. Market sentiment towards China, especially from the international investment community, is so bad that one would wonder what else lies in the China “tail risk” that could catch the market by surprise.
Some serious investors are questioning if the PBoC would devalue the renminbi to help China’s GDP growth; if devaluation would be effective to revive China’s economy; and what would be impact of renminbi devaluation on the US Federal Reserve’s interest rate policy?
Empirical evidence shows that renminbi depreciation would only have a marginal effect on China’s export growth. The predominant factor affecting Chinese exports is global demand. This is seen in the fact that since the mid-1990s, China’s global export market share has been rising steadily, despite a rising trade-weighted exchange rate of the renminbi.
In fact, on a trade-weighted basis, the renminbi has become the most expensive currency in Asia for more than 10 years. But the Chinese have not lost export market share, thanks to rising global demand, until recently.
Furthermore, exports have a declining impact on Chinese growth since 2009, with net exports dragging on GDP growth rather than contributing to it.
According to my estimate, the PBoC would have to devalue the renminbi against the US dollar by 20 to 40 percent to make some material impact on Chinese GDP growth. But that would be a move unacceptable even by China.
That extent of devaluation would be like China shooting itself in the foot because it would cause other currencies to fall, aggravating the currency war and pushing the impact of renminbi devaluation back to square one.
If the current negative sentiment towards China does not change, market forces would push the renminbi down by about 3 percent year on year against the US dollar this year, and by another 3 percent next year, according to my estimate. This would not have any material impact on Chinese GDP growth.
Thus, the expected benefit of renminbi depreciation will be marginal.
But the cost will be huge. Financially, large and persistent declines in the renminbi will push those Chinese companies which had borrowed unhedged in US dollars into financial trouble, posing systemic risk to China.
It will also create a vicious cycle of devaluation expectation and destabilizing capital outflows. There will also be significant political backlash against renminbi devaluation.
Simple cost and benefit comparison argues that currency devaluation should not be in the PBoC’s cards.
Crucially, devaluation will not solve China’s economic problems, which stem from its transition to a new growth model.
China’s tertiary sector has been growing faster and is now larger than the secondary sector.
Expanding demand for services, such as healthcare, education, tourism, entertainment and financial products, is less dependent on expanding industrial output, investment and exports, and less demanding for power consumption, raw materials and freight.
Hence, the lack of growth momentum of these traditional macroeconomic output indicators is giving a distorted picture of China’s growth.
If further weakness in the renminbi reflects further weakness in global demand, it would likely prompt the Fed to postpone its rate hike plans.
If further decline in the renminbi causes other currencies to fall against the US dollar, which I believe it would, it could also prompt the Fed to delay interest rate hikes, as the surging US dollar would tighten liquidity conditions and be quite deflationary for the United States.
If my view on a 3 percent depreciation of the renminbi against the US dollar is right, I do not think it will affect the Fed’s policy.
But there is a “tail risk” that has been ignored by many market players so far: In the coming months if the renminbi remains stable (which I believe it will), if China’s economy starts to stabilize (which is likely), and if the renminbi is admitted to the International Monetary Fund’s Special Drawing Rights basket (which has a more than 50 percent probability of happening, in my view), the market will have to admit that China’s economic growth had not crashed.
Those who have sold China short may then wonder why they were involved in a negative carry-trade based on fundamentals that are not as bad as they thought and given that those imagined crisis catalysts never materialized.
When they start covering their short positions at a time when the renminbi is under-owned and when China runs the largest trade surplus in the world, Chinese asset prices and the renminbi exchange rate will just have to rise.
This may be a benign “tail risk” to have.
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