Why China Won't Big Bang Devalue The Yuan

(MENAFN- Asia Times) As net capital outflows exceed China's current account surplus, the yuan currency will necessarily face depreciation pressure. However, China will neither float its currency nor allow a large depreciation.

Floating a currency in the global financial system now dominated by the US means making the country's financial system more exposed to US actions. China's strategy is the opposite: to reduce its vulnerabilities to the US-dominated systems.

Selling foreign currency reserves to defend the exchange rate is also not an optimal policy for the People's bank of China, the central bank. Such an operation would tighten domestic liquidity and could push up local interest rates.

For an economy suffocating from deflation, tightening liquidity is the last thing China needs. This set of circumstances has led to rising expectations in the global investment community of a yuan devaluation-in the form of a swift or one-off exchange rate adjustment.

Under certain circumstances, for a managed, pegged exchange rate system like China's, a one-off or rapid devaluation might be preferred to a slow, gradual depreciation.

The thinking is that growing expectations of currency depreciation could lead to escalating capital outflows. These dynamics can become self-fulfilling and often cannot be reversed without a material exchange rate adjustment.

However, Beijing will not resort to a one-off or rapid devaluation, at least not for now. The cost-benefit analysis of this option is unfavorable from the perspective of Beijing's current policy priorities.

Latest stories

Japan's plan to dominate software-defined vehicles

Huawei plans to make 3nm chips, but when?

Drones filling the skies over Ukraine battlefields

First, the PBoC manufactured a small 2% devaluation of the yuan in August 2015, which resulted in a collapse in share prices, both in China and globally. That episode is no doubt still fresh in PBOC policymakers' minds.

Second, a rapid yuan depreciation will (1) hurt consumer and private business confidence and delay economic recovery, (2) heighten tensions with the US in a volatile election year and (3) undermine China's efforts to internationalize the yuan. For Beijing policymakers, these negatives likely outweigh the positives of a currency devaluation.

Finally, Chinese exports are already very competitive and small-to-moderate currency weakness will do little to boost them in the near term. Demand for mainland exports is constrained by (1) weak income or low propensity to buy all types of goods in overseas markets and (2) tariffs that some countries, like the US, have imposed on its products.

A preemptive and large devaluation of the yuan would make it more likely that others, like the EU, will join the US in imposing substantial tariffs on Chinese products.

The PBoC will thus allow only gradual and moderate currency depreciation – in the ballpark of 5% – for the rest of this year. So would this outlook not justify even more capital outflows in anticipation of further currency depreciation? It likely would.

However, authorities will probably respond by implementing stricter administrative controls to curtail capital outflows. This will eventually render vulnerable those market players who have so far benefited from capital outflows from the mainland.

Critically, mainland residents' investments in gold, other metals and Hong Kong-traded Chinese stocks are forms of capital outflows, all of which weigh against the yuan's value.

The PBOC controls all gold imports so it can temporarily curtail the quota for gold imports and force sellers (banks and trading houses) in China to stop offering gold and gold-linked products to onshore investors.

That said, we maintain that the PBOC will continue diversifying its international reserves away from US dollars. Diversification entails continuous purchases of gold because there are few alternatives to the greenback or the Western bloc's other currencies. Therefore, any pullback in gold prices will likely be mild and transitory.

Notably, when monetary authorities use their international reserves to buy gold, this does not represent capital outflow and does not affect the currency's value. The basis is that, unlike residents, the central bank uses its US dollars, not local currency, to buy gold.

On another note, onshore investors have been pouring capital into Chinese stocks listed in Hong Kong via the Southbound Stock Connect program. These stocks are quoted in the Hong Kong dollar, which is pegged to the US dollar.

MENAFN30052024000159011032ID1108274433

Legal Disclaimer:
MENAFN provides the information “as is” without warranty of any kind. We do not accept any responsibility or liability for the accuracy, content, images, videos, licenses, completeness, legality, or reliability of the information contained in this article. If you have any complaints or copyright issues related to this article, kindly contact the provider above.