With the yuan at its lowest level against the dollar in five years, November seems far away. Yet it was not even two months ago that the IMF crowned the renminbi (RMB) as a member in one of the world’s most exclusive clubs: the Special Drawing Right (SDR), a basket of the world’s reserve currencies.
Feeling emboldened, China’s central bank came up with what they thought was a clever stimulus package. By allowing the yuan to depreciate against the U.S. dollar – by adjusting the level at which the value of the yuan is fixed to the U.S. dollar (shown below) – they hoped to control the yuan’s value in the face of heavy downward pressure from the market. But so far this year, speculators have kept selling the yuan and the yuan keeps losing value — starting a vicious cycle that has caused more and more investors to sell.
Last week’s 10% decline in the Shanghai Composite Index isn’t even the worst of it. The far greater risk is that the currency is in free-fall. It’s fallen another 1.2% against the U.S. dollar since the start of this year – that’s a big move for the yuan. Reuters reported recently that Beijing is under heavy pressure by debt-laden Chinese firms to let the yuan fall by up to 15%, because a lower currency will make it easier for them to pay back their yuan-denominated loans.
Most outside traders believe the yuan is overvalued by more than 10%. But allowing the yuan to fall that much would devastate China’s domestic economy as foreign investors, and native Chinese, would likely start taking money out of China and investing it elsewhere, since nobody wants to hold investments in a currency that’s falling. And China’s central bank has yet to learn that markets always win.
Just how much has the yuan’s slide cost China? In the last month, China has used almost $108 billion in reserves, which is the foreign currency holdings they’ve stockpiled, trying to support the yuan. That’s following a brutal November when they lost $87 billion in reserves. They do have some $3.3 trillion still left in reserves, but only about $1 trillion of that is liquid enough to be used right away (the rest is tied up in longer-term investments and foreign assets).
Here are China’s options:
- Defend the yuan: the Peoples Bank of China (PBOC), China’s central bank, sets a price for the yuan at which it will defend it against outside speculation and they hope to not run out of foreign currency reserves before the rush to sell the yuan ends
- A one-time devaluation: they jump ahead of the speculators with a massive devaluation and let the yuan drop so low that the currency will actually rise, because speculators will now want to own it because it’s corrected too far
- A gradual, controlled depreciation: a combination of the previous two tactics, leading to a steady fall towards the 10% depreciation target
The last time China devalued its currency to this extent was 1994. With a smaller economy and fewer ties to the rest of the world, it fell by a third overnight, causing slight tremors throughout the market (and hurting their Asian neighbours in the process).
But this time around, China’s currency problems have become the world’s problems. When China’s currency weakens, its purchasing power decreases, reducing demand for global commodities and imported goods. That hurts oil and emerging market economies like Brazil and Russia that depend on China to buy their natural resources.
And the damage isn’t just limited to commodities and emerging markets. Many developed economies, like Germany’s, are closely linked to China, which is becoming one of their most important trading partners.
Many investors think China’s volatile stock market is what’s been driving recent swings in global markets. But China’s yuan exchange rate has more of an impact than its local stock market. And the potential devaluation of the yuan could even trigger a cycle of currency devaluations in other countries. In fact, far away Mexico spent $400 million dollars last week to provide support to its falling peso.
Since this past summer, China has shifted policy from liberalizing their currency regime — and slowly, their domestic economy — to stabilizing their markets and currency. But they’ve been heavy-handed in their approach: blocking capital from leaving and suspending the accounts of foreign investors speculating against the yuan. At this point, the Chinese government is more interested in controlling the yuan’s value than following the rules of the IMF’s SDR club.
One sign that the problem may get worse before it gets better is the growing spread between the yuan exchange rate in Hong Kong, where it is freely traded (the offshore rate), and in mainland China, where it is not (the onshore rate).
A cheap yuan is great for Chinese exports, but it’s a double-edged sword. A too-weak yuan increases the risk investors will take their money out of China and makes life difficult for Chinese companies with debt denominated in U.S. dollars. A drop in the exchange rate to 7.70 yuan for one USD (from the current 6.59) would boost exports by around 10% in 2016 and add 0.7% to GDP (gross domestic product). But that would result in capital outflows of an enormous US$670 billion, according to a survey by Bloomberg.
China’s problems aren’t going to let up without broader changes in the country’s economy, like forcing debt-laden state-owned enterprises to stop borrowing and shutting down struggling firms. This would make it easier for investors to figure out how China’s financial system is really doing.
But until then, all signs point to a broader slowing down of the economy and more drama ahead.