Impasse of competitive devaluation
by Ben Robinson
Fears of a competitive devaluation of the renminbi and an impending currency war are overstated. Such fears rest on the assumption that China may pursue devaluation to boost exports and support its flagging economy, which in 2015 slowed to its lowest growth for 25 years.
China devalued 2% in August and substantially lowered the renmimbi’s reference rate in January. The delinking of its currency peg to a basket of other currencies has been naturally reflected in a depreciation against the dollar. Despite all this, a committed policy of devaluation would harm the Chinese economy.
Part of last year’s GDP slowdown stemmed from declining growth in both fixed-asset investment and manufacturing output – these fell by around 2% and 18% respectively compared with the previous year. Reinvigorating these sectors through devaluation would not put China back on the path to faster growth.
Large-scale investment has shown diminishing returns over the last few years as a result of growing overcapacity. High borrowing to fund infrastructure and other investment projects is weighing on the country’s fiscal balance, with total debt now standing at around 250% of GDP.
China’s future growth depends on rebalancing away from investment as a proportion of GDP. Currency depreciation and looser monetary policy to reduce domestic borrowing costs would hinder efforts in this direction.
Nor would currency depreciation unambiguously help China’s manufacturing export competitiveness, given that China imports around 35% of the components for the goods it then exports.
Much of the imported content of China’s exports is the high value-added, research and design-intensive element of the goods, which China predominantly imports from the US, Japan, Taiwan and South Korea. Depreciation would make these imports more expensive and increase the production costs of its higher-value exports.
While goods with a high domestic content would become more competitive on export markets, China’s high domestic-content exports are still relatively low-value. Boosting these sectors through devaluation would set back attempts to rebalance its economy away from lower-value manufacturing and towards higher-value services and consumption.
The limited extent of China’s rebalancing is illustrated by Chart 1. Although services appear to be taking over from manufacturing, this is largely the effect of a decline in the nominal value of manufactured goods due to falling input costs.
Adjusting for inflation, manufacturing as a share of output has fallen only slightly in recent years. Meanwhile, the associated producer-price deflation has harmed cashflow and increased the real value of debt for China’s manufacturers, raising the pressure on these highly leveraged firms.
The lack of progress on China’s economic rebalancing in real terms, and the growing strain on China’s traditional producer firms, bring important consequences. The results are twofold. A currency depreciation aimed at increasing the manufacturing industry’s competitiveness by reducing total costs would further harm the profitability and cashflow of Chinese producers.
Additionally it would pose a threat to China’s economic reforms and attempted move towards a more sustainable growth model.
Much of the current downward pressure on the Chinese currency comes from the size of capital outflows, which totalled a net $676bn last year (Chart 2).
The strain on domestic producers is one reason for this outflow, with local firms desperately seeking growth outside of China. This led to a $32bn outflow of capital in the form of increased outward direct investment during the third quarter of 2015.
Foreign firms have rapidly limited their direct investment into China, which fell $32bn over the same period.
As US interest rates begin to rise, many Chinese companies have been paying down their foreign debts. Some capital outflows have therefore been beneficial, since they have effectively financed corporations’ action in paying off foreign debts.
As a result many Chinese companies have healthier balance sheets and fewer liabilities. However further depreciation would be counterproductive, creating a less beneficial environment for national companies and foreign investors. Rather than encouraging economic activity, this could spur faster capital flight.
Depreciation would impose restrictions on China’s monetary policy options and reduce the policy tools available to deal with these issues. Stemming outflows resulting from depreciation may require the imposition of severe capital controls, a move suggested by Bank of Japan Governor Haruhiko Kuroda. Though this would create room for the central bank to expand monetary policy, it would severely limit inward foreign investment.
Moreover, the government could take advantage of cheap central bank money to finance an expanded fiscal stimulus in an attempt to boost domestic demand. The combination of loose monetary policy and fiscal expansion would risk returning the country to unsustainable borrowing and a dependence on fixed investment. This could lead to further overcapacity and the risk of exporting deflation, creating a negative feedback loop – consequences underlined by recent analysis from the International Monetary Fund.
China is aware of these risks, spending a record $108bn in December and almost $100bn in January to help maintain the value of the currency, while aggressively targeting the spread on the offshore renminbi rate. This suggests a renminbi devaluation of up to 10%, anticipated by some market commentators, is not desired by the government.
Smaller reductions in the reference rate are likely, but these are primarily to manage the effects of a rising dollar. Policy-makers recognise the dangers that depreciation presents to the health and long-term prospects of the Chinese economy and its attempts at rebalancing.
The real challenge for China is maintaining the value of its currency while fixing the weaknesses in its capital account position that are contributing to the downward pressure on the exchange rate. This is where capital controls can play a part.
A rise in the dollar will heap further pressure on China’s official reserves, while further capital outflows will reduce already shaky confidence in China’s economy. Depreciation would not help this predicament. Back