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Analysis
Renminbi depreciation chances growing

Renminbi depreciation chances growing

Case of economic realities rather than 'weaponisation'

by Mark Sobel in Washington

Thu 30 May 2019

With the intensification of the latest US-China trade salvos, the renminbi has fallen anew. It is approaching Rmb7 per dollar, a figure imbued by markets, and perhaps authorities, with significance.

The US and China appear headed for a trade stalemate for the longer haul. While a trade deal would create global risk-on sentiment and strengthen the renminbi, the probabilities it could breach Rmb7 per dollar are escalating, not because of 'weaponisation' but rather economic realities.

The authorities are well aware that renminbi depreciation versus the dollar offsets the loss in competitiveness from US tariff increases, and thus a falling renminbi will anger President Donald Trump's administration as trade negotiations proceed.

After its currency's severe weakness in 2015-16, China is undoubtedly concerned that sharp depreciation versus the dollar could stimulate a renewed wave of capital outflow.

Over the last year, China sought to resist sharp renminbi depreciation against the dollar, though the currency weakened as the Federal Reserve increased rates. Further, trade tensions fostered a risk-off environment, weakening the renminbi against the dollar.

In the face of these developments, China jawboned, intervened at times, and used other measures such as squeezing short positions to steady the currency.

No one can predict successfully where exchange rates are headed. But increasingly, the probabilities are rising that the renminbi could breach the Rmb7 per dollar threshold.

China's massive current account surpluses of a decade ago have disappeared. The current account is now flat or in slight surplus. The International Monetary Fund predicts China will run small current account deficits in coming years. In recent years, tighter controls have constrained net capital outflow. Reserves have held steady, around $3tn.

The outlook for the capital account is uncertain.

On the one hand, Chinese investors have many reasons to export capital. They are wealthier. Their portfolios are not internationalised.

Many investors apparently would feel more comfortable holding considerable capital abroad due to concerns over the economic outlook, a rickety Chinese financial system and a state bent on increasing its influence over business and society. Notwithstanding the strength of Chinese controls, experience around the world highlights clearly that capital controls leak.

On the other hand, international flows will seek to enter China, especially passive flows as Chinese equities and bonds enter global indices.

How these forces balance out merits close scrutiny. But one cannot dismiss the possibility that substantial net capital outflow could emerge, on top of a flat current account or slight deficit, pushing the renminbi well lower versus the dollar.

China maintains unsustainably high growth targets – for 2019 of 6%-6.5%. But the Chinese economy weakened sharply toward the end of 2018 and early 2019, due mainly to the authorities' campaign to fight growing financial risks and excess leverage.

Following the injection of significant stimulus, the outlook is steadying. But it is still not strong by Chinese standards, and the trade spats only further dampen and cloud China's growth outlook.

Fiscal policy obviously has a role to play in supporting growth. So does monetary policy, and the People's Bank of China has reduced reserve requirements and injected liquidity to guide rates lower, though overall financial conditions may not be so loose.

One way to buoy the currency would be to tighten monetary policy, but this would go against domestic objectives. Orienting monetary policy toward the renminbi-dollar exchange rate would run counter to the PBoC's efforts to modernise China's monetary policy framework and promote greater exchange rate flexibility.

The authorities could use their $3tn in reserves to draw a line in the sand. But just as authorities have been concerned a sharp fall below Rmb7 per dollar might trigger a wave of capital outflow, they are also worried that sharp reserve drawdowns might have a similar effect.

In short, while analysts focus on Rmb7 per dollar, the $3tn threshold is also highly critical to authorities. It is one that they do not wish to breach.

China does not now face the massive unhedged position that it did in 2015, when renminbi appreciation against the dollar was presumed to be a one-way bet. Still, should significant net capital flows find their way out of China, the authorities may find themselves caught in a difficult position – the Scylla of domestic objectives and the Charybdis of external objectives.

History teaches us that large countries especially are resistant to subordinate domestic objectives to external disciplines. Reluctant to tighten monetary policy or significantly draw down reserves, Beijing may continue throwing sand in the gears of renminbi depreciation. In doing so, it will hope that any possible slide past Rmb7 per dollar is slow and gradual, and will not trigger a wave of global financial instability and self-reinforcing capital outflow.

The Chinese currency may well sink below Rmb7 per dollar in this scenario. It will not be 'weaponisation'. It will be economic reality.

Mark Sobel is US Chairman of OMFIF.

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