By Houze Song
In the past few days, China’s currency, the renminbi (RMB), has depreciated by more than 3% against the dollar, leading to widespread speculation that China is trying to stimulate its slowing economy through currency depreciation. In my opinion, that analysis is wrong—and China probably couldn’t depreciate the RMB much more in today’s zero interest rate environment, anyway.
First, the message in People’s Bank of China’s (PBOC) statement suggests this is most likely a once and for all adjustment, not the start of a depreciation trend. The depreciation is the result of aligning the daily benchmark rate (which is set by the PBOC) with the market rate.
The PBOC has been trying to dampen pressure for depreciation by maintaining the daily benchmark rate at a level higher than the market rate. But this hasn’t fully convinced the market, and private capital has been fleeing China. The reason is largely because the US is approaching a rate-hike cycle, while China has been cutting interest rate to boost growth. This increases the relative attractiveness of dollar assets, as US interest rates are expected to rise in the coming years. Demand for dollar assets will drive the dollar higher against other currencies.
With the US Federal Reserve close to making its first interest rate hike in nine years, China’s depreciation will provide the PBOC with some breathing room, moving the exchange rate to a level consistent with market expectations. By depreciating now, China could avoid a sudden drop in the RMB exchange rate should the Fed hike rates in September. In short, the PBOC has introduced a reform that lets the market play a bigger role in the RMB exchange rate; indeed, in the past few days, the market has been pushing the RMB down. But the room for further RMB depreciation is probably limited.
The reason further depreciation is unlikely is twofold. First, consider the potential Fed response. Significant RMB depreciation will bring further downward pressure on inflation in the US and increase the US trade deficit with China. US inflation has been below the Fed’s 2% target for more than 3 years, reflecting weak economic growth, and it is the main factor why the Fed has not increased rates.
China accounts for around 20% of US imports, and so cheaper Chinese imports resulting from an RMB depreciation would likely decrease inflation even more. More importantly, cheaper Chinese goods would reduce demand for US products, ultimately leading to a slowdown in US economic and employment growth. In sum, the Fed would have to delay its rate hike if there is a persistent sizable depreciation of the RMB, as a weaker RMB would drive both inflation and employment below the Fed’s target.
The market’s expectations about the Fed’s reaction will actually limit the scope of further RMB depreciation because a slowdown in rate hike would mean lower future returns on dollar assets, leading to a weaker dollar. And that is precisely what we saw in yesterday’s currency and bond markets: The US dollar depreciated against all major currencies, and US Treasury yields dropped significantly. The reason: people expect that future US interest rates will be lower than previously expected (because of a delay in Fed action).
The second reason that this is most likely a one-off depreciation is that gradual depreciation does more harm than good to the economy. If market participants expect more depreciation will come, then everyone will want to convert their RMB holdings into dollars. We have repeatedly witnessed this during currency crises. If the central bank fails to stabilize the exchange rate during a period of depreciation, then the situation could evolve into a self-fulfilling currency crisis. The PBOC is well aware of this problem, and has reassured the market that the RMB exchange rate will continue to be a managed floating exchange rate regime. Such concern about managing market expectations also explains why the PBOC depreciated the RMB by such an extent. This kind of swift adjustment minimizes the likelihood of fueling depreciation expectations and a possible run on the RMB.
The bottom line is that under the current economic environment, any orchestrated Chinese effort to stimulate the economy would be countered by competitive depreciations and tensions with China’s trading partners. In the first half of 2015, China’s current account surplus already accounts for 3% of GDP. Any further increase of China’s surplus would be a reflection of less demand for other countries’ goods. With the current weak global economy and trade growth, a continuing depreciation—and increasing surplus—would be extremely dangerous and, ultimately, self-defeating.