Why a large RMB devaluation is unlikely

September 07, 2015 10:02
China's devaluation of its currency is a step towards increasing market forces in renminbi trading. Photo: Bloomberg

Global financial markets nearly imploded when China changed its renminbi daily fixing mechanism in August, which led to a more than 3 percent devaluation of the currency against the US dollar.

China’s economy is on the brink of collapse, pessimists warned. A new era of currency wars is about to be unleashed, doomsayers added, with some observers calling for 10 percent or more devaluation for the yuan.

Granted, the Chinese economy has been slowing, and devaluation could be viewed as an aggressive move to generate some growth momentum by boosting exports.

But it could also prompt an all-out currency war when Chinese export competitors also push down their exchange rates. In this regard, investors are right to be worried about a large renminbi devaluation.

But how serious is the threat? In reality, China’s devaluation was immaterial.

Compared to the euro’s 20 percent drop so far this year, or the yen’s 35 percent dive since Japan embarked on its “Abenomics” reform program in late 2012, it is clear that overblown headlines about the renminbi’s “plunge” were totally misleading.

Had China really wanted to grab a bigger share of world exports, it is hard to imagine that its policymakers would have settled for such a modest adjustment.

Economic theory shows that even rational governments have strong incentives to engage in currency wars, even though they are negative sum games when everyone is involved.

Some analysts are predicting double-digit devaluation of the renminbi (without specifying the timeframe), which is an important tail risk given weakness in the euro and yen.

However, the problem with competitive devaluation is that one country gains at the expense of the other.

The resultant increase in foreign exchange volatility will raise the cost of international trade and investment, leading to contraction in capital flows and global growth and, thus, a lose-lose outcome.

So will China be dragged into the battlefield of competitive devaluation? The following strategic analysis helps us analyze FX policy decisions and sheds some light on China’s strategic position in the currency war.

Assume two countries, Europe and Japan, do not communicate with each other on their FX policy moves. Each has the option to either devalue its currency or stay put.

If Europe devalues but Japan stays put, Europe gets 1 percent growth and Japan contracts by 2 percent, as Europe gains by attracting foreign direct investment and boosting GDP growth at the expense of Japan.

On the other hand, if Europe stays put and Japan devalues, its growth shrinks by 2 percent while Japan gains 1 percent.

If both stay put, there would be zero impact on their economic growth.

It is clear that no matter what the other country decides, each gets a higher pay-off by devaluing its currency. The reasoning involves a dilemma that neither country knows what the other will do.

The latest episode of the currency war has been fought at the expense of the US dollar and the renminbi, whose trade-weighted exchange rates have risen sharply.

In China’s case, both its nominal and real effective exchange rates have risen for more than a decade, but the rate of appreciation has sped up since the currency war started in 2010.

China’s weak growth and intensifying deflationary pressures are creating concerns among some Chinese officials about the strong renminbi further damaging the local economy.

Hence, some market players are predicting that China might join the currency war by devaluing the renminbi to find an escape route.

I disagree. The People's Bank of China's recent move on changing the daily fixing’s calculation is a reform step towards increasing market forces in renminbi trading.

Beijing will probably continue to resist the devaluation temptation because empirical research shows that it would not significantly help China’s exports and economic growth; it could lead to destabilizing capital outflows due to expectations of further devaluation; and it could exacerbate the financial burden of those Chinese companies with large and unhedged foreign currency (mainly US dollar-denominated) debt.

The move to reform the daily fixing regime does signal a minor policy shift from the previous “stable renminbi with a strong bias” to now “stable renminbi with a weak bias”, with the bias being determined by market sentiment.

But it is not a harbinger for China entering the competitive devaluation game.

A corollary of China joining the currency war is that it could exacerbate the Asian currency battles and send global rates lower. It would also be bearish for commodity currencies, which track Chinese demand.

The resultant market volatility would be bullish for US Treasuries, as capital flows head for a safe haven. This would reinforce the downward pressure on global interest rates.

As for China, Beijing still has firepower to stabilize the domestic market and economy, including further monetary and fiscal easing and deployment of policy bank lending as an additional cheap long-term financing means to revive GDP growth.

Keeping liquidity ample is crucial to containing the stock market rout. The ultimate turnaround in investor sentiment will only come when macroeconomic data starts showing an economic revival.

That will take at least a quarter or two to realize, even if Beijng gets its policy right.

Opinions here are of the author’s and do not necessarily reflect his employer’s.

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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”