How will China’s currency respond to slower growth?

June 01, 2022 06:00
Photo: Xinhua

The rise of China into the upper echelons of the world economic order underscores the sway it has over how the global economy performs from the perspective of its appetite for commodities from grains to energy to metals, as a key bilateral trading partner, an important investor in resource-rich nations, and its status as a powerhouse since becoming a member of the World Trade Organization in 2001.

In this article we will examine the role China plays in the global economy in terms of its contribution to trade flows, the modern origins of its growth in prosperity going back to the 1970s, its current challenges from the troubled property sector, slowdown in growth and pace of exports, and its renewed battle to contain an outbreak of COVID-19 that has led to lockdowns.

The Rise of the Chinese Dragon

China’s economy began its metamorphosis into what it is today with reforms initiated by Deng Xiaoping in the 1970s and 1980s that included the crucial opening up of parts of the country to foreign investment.

The reforms set in motion the rapid expansion of the Chinese economy, which was valued at $14.7 trillion in 2020 by the World Bank.

How did China’s economy prosper and become a major player on the world stage? It’s vast labor pool provided the foundation for growth, focusing on exports. In fact, China is the top supplier of goods to the United States, and is the third largest market for U.S. products, with the countries locked in a symbiotic trade relationship despite the occasional political flare ups.

Having been reliant on exports for its exponential growth for decades, China is now moving to make domestic consumerism its hallmark, to tap into its growing middle class and its attendant affluence. China’s per capital income has surged from just $194 in 1980 to $10,434 in 2020, uplifting millions from an agrarian economy in a massive shift to industries and an urban lifestyle.

The global dependence on China as a “factory to the world” became evident during the height of the pandemic when supply chains were snarled by its lockdowns, and the subsequent rise in inflation as a sequestered world shifted its demand from services to manufactured goods produced primarily in China.

Exports have been the centerpiece of the Chinese economy, and their growth over the years have been significant. Exports began to take off in earnest in 2002, from $256 billion to $1.61 trillion in 2008. Exports were set back during the recession that year. The recovery began in 2009 to top $2 trillion in 2011 and $2.7 trillion in 2014. A slowdown in exports in 2015 marked China’s slowest annual pace of growth in more than two decades.

Headwinds ahead for China?

Most recently, China’s economy has slowed sharply in late 2021 and early 2022 to below 5% growth rates and China isn’t alone in experiencing a slowdown. The International Monetary Fund (IMF) expects global growth to moderate from 5.9% in 2021 to 3.9% in 2022, largely reflecting its scale-back in forecasts for the U.S. and China. The IMF cites renewed disruption from the pandemic and financial stress among property developers for a 0.8% mark down. The bank, however, upgraded its forecast for 2023 to 3.8% from 3.6% due to “a mechanical pick up after current drags on growth dissipate in the second half of 2022.”

China has been dealing with its troubled property sector by cutting benchmark mortgage rates to bolster home purchases, while at the same time the Peoples Bank of China (PBOC) has reduced short- and medium-term lending rates to bolster an economy that faltered in the fourth quarter of 2021 to 4% -- its slowest pace in decades except for the early 2020 lockdowns.

The IMF projects China’s growth to slow down to 4.4% in 2022 from a projected 7.9% in 2021 due to “to the rapid withdrawal of policy support, the lagging recovery of consumption amid recurrent COVID-19 outbreaks despite a successful vaccination campaign, and slowing real estate investment following policy efforts to reduce leverage in the property sector.”

In the past, China’s government has used generous fiscal policies to shore up any slack in the economy. But, over the long-term, this could be a challenge due to large debt relative to its GDP.

How will China’s Currency Respond to Slower Growth?

Because China maintains relatively strict regulations on the flow of capital into and out of the country, export growth plays a much more important role in exchange rate dynamics than for most countries. And, it has been the strong pace of China’s exports which has underpinned its yuan, strengthening over the past two years against the U.S. dollar from 7.10 yuan to the dollar to the 6.30-6.40 range. But the recent lockdowns in China had the yuan weakening to the lowest level in a year against the dollar.

Will the yuan maintain its relative strength against the dollar or will it weaken further? If the past is any guide, export growth will be key, rather than shifts in monetary policy at the Fed. And, there are several scenarios for export growth. The pandemic brought a shift in spending in the U.S. and in Europe away from services and towards goods, many of which are produced and exported by China. Within China, the degree of lockdowns due to COVID at port cities, such as Shanghai, may also slow exports by delaying shipping.

As Europe and North America move toward a more open and less restrictive management of COVID-19, many analysts expect a return to more personal income being spent on services and less on goods. To date, however, even as economies have re-opened, spending on goods remains elevated relative to services. If global growth slows, as the IMF suggests it might, then Chinese exports may decelerate as well. In sum, the Chinese yuan may be in the crosshairs of any change in consumption patterns back toward goods or a slowdown in global growth.

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Director, Economic Research, CME Group