- China may have to let yuan weaken as foreign reserves fall
- Previous two dollar cycles both triggered joint interventions
The world’s central banks should plan for coordinated currency intervention akin to the 1985 Plaza Accord to support the Chinese yuan and keep the dollar from strengthening more, according to Deutsche Bank AG.
“It is not too early for the U.S. and other major global players to consider how best they can support China in a transition to a market determined exchange rate,” Alan Ruskin, New York-based global co-head of foreign-exchange research at Deutsche Bank, the world’s second largest currency trader, wrote in a note on Tuesday.
Joint currency interventions helped stem the previous two dollar strengthening periods since the 1980s, and “it is quite likely that similar actions will be needed in this big USD cycle,” he wrote.
The yuan has weakened about 6 percent against the dollar over the past six months as the economy slowed and capital outflows mounted. The decline has roiled global markets and prompted the central bank to spend a record $513 billion in foreign reserves to shore up the currency.
Some investors are concerned that, at the current rate of declines of about $100 billion a month, China’s $3.3 trillion foreign reserves may soon fall below adequate levels.
Should capital controls fail to stem outflows and slow the pace of depleting reserves, China may have to give up intervention and allow the currency to weaken, said Ruskin. That may cause the dollar to surge, to the detriment of the U.S. and other global economies, he added.
“If China’s currency starts to weaken more than desired by both China and the global community, or China’s reserve erosion fails to slow despite macroprudential measures, coordinated intervention would likely be top of the list of prospective actions,” the strategist said.
In 1985, the U.S. and its allies were forced to band together in the Plaza Accord to drive the dollar down after the currency’s appreciation led to an outburst of trade protectionism. The Federal Reserve, the European Central Bank and Bank of Japan also joined forces to prop up the euro in 2000.
This time, intervention may involve the U.S. selling dollars and buying Chinese and foreign assets, said Ruskin. It may also include interest rate cuts by the Fed to weaken the greenback.
The Fed’s gauge of the dollar against major U.S. trading partners has increased more than 40 percent since reaching a record low in May 2011.
The index surged 67 percent from a trough in 1978 to a peak in February 1985, seven months before major central banks signed an agreement at the Plaza Hotel in New York to weaken the U.S. currency. By the end of 1987, the dollar had dropped about 40 percent from the peak.
“It is far easier to weaken a strong currency than strengthen a currency with a weakening bias,” Ruskin wrote in his report.
To anchor investor expectations, the Chinese authorities have stressed that it aims to keep the yuan stable against a basket of currencies, breaking its tie to the rising dollar. They have also tightened capital controls to stem outflows, which amounted to $1 trillion last year based on data compiled by Bloomberg.
Bank of Japan Governor Haruhiko Kuroda said at the World Economic Forum last week that capital controls are a preferred way to defend the yuan rather than keep burning through reserves. Concerns about capital outflows sent the Shanghai Composite Index of stocks down more than 6 percent Tuesday to a 13-month low.
In Tuesday’s note, Ruskin said the restrictions are only a short-term solution because they inhibit the process of balancing supply and demand and erode investor confidence.
While it is not the best time to relinquish controls on the exchange rate when the economy is slowing and the debt level is rising, a “strong” counter argument is that China needs to preserve foreign reserves in case it needs to bail out financial institutions as the credit cycle turns, said Ruskin. It is a better way to deploy the reserves than supporting a currency valuation that is “not consistent with market forces,” he said.