China's Currency Policy Approaches Breaking Point
In his first few weeks in office, President Donald Trump has ordered the U.S. to withdraw from the Trans-Pacific Partnership and confirmed his intention to renegotiate the North American Free Trade Agreement. The consensus is that it won’t be long before he turns his focus to China, which he calls a currency manipulator.
China can weather such criticism, for now. But if Trump’s threats of trade sanctions and 45 percent tariffs become real, the economic impact for the world's second-biggest economy would be meaningful and could upend financial markets, potentially leading to a global recession. With economic growth already slowing and capital fleeing the nation, China's $11 trillion economy is operating from a position of weakness.
Here’s how it plays out: As the world’s dominant reserve currency, the dollar has no peer. International Monetary Fund data show that the greenback accounts for 63.3 percent of global foreign-exchange reserves, with the euro next at 20.3 percent, followed by the British pound and Japanese yen, both at 4.5 percent. That means that in times of crisis, the dollar benefits from global investors seeking a haven, even if the strife and the the uncertainty emanates from the U.S.
It’s possible that a trade war would drive flows into the dollar, putting upward pressure on the currency at the expense of other exchange rates. That would be on top of the natural demand for the greenback created by the anticipation of significant fiscal stimulus floated by the Trump administration and a faster pace of interest-rate increases by the Federal Reserve.
In terms of China, it’s important to remember that the yuan’s external value is managed by authorities in a way that isn’t compatible with a sharp appreciation pressure of the dollar vis-à-vis all other currencies. The currency is managed to achieve a stable, effective, trade-weighted exchange rate and to foster a gently crawling peg relative to the dollar. That peg would be threatened if a trade war weakened China’s economy at a faster rate than forecast. What was presented as a gradual depreciation of the yuan last year was in reality a significant 6 percent weakening of the currency versus the dollar as China’s domestic woes mounted. A collapse of the crawling peg could lead to yuan depreciation that is three times as large.
Although the pace of depletion of China’s foreign-exchange reserves has eased from $100 billion per month in late 2015, the leakage shows no signs of abating. The $3 trillion official figure for China’s reserves probably overstates the amount of dollars actually available for intervention to support the yuan by at least $1 trillion, possibly more. At least $500 billion of reserves are “encumbered” by forward sales of dollars by the Chinese authorities, which they will actually have to deliver in the future.
The IMF estimates that China needs at least $2.6 trillion of “working capital” to allow companies and the government to conduct import/export operations. The “working capital” is unlikely to be available to defend the yuan because that money has to be held “in reserve” as a fiscal backstop if systemically important Chinese firms with dollar exposure are threatened with insolvency.
Although China may be nearing the point where a significant devaluation of the currency would make sense, there are obvious reasons that the authorities would want to avoid a sharp weakening of the yuan anytime soon. First, the domestic political cost of a collapse of the currency in the year leading up to the 19th Party Congress would be significant. Second, a sharp bilateral weakening would provide the Trump administration with the ammunition to declare China to be a “currency manipulator” and impose trade or investment-related sanctions. The authorities will do everything they can to avoid a hard yuan landing before the party congress.
It’s clear that China’s current currency policy is unsustainable. It can, of course, last longer than anyone anticipates, and then abruptly end. That’s the likely fate awaiting the crawling peg.
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