What lies beneath China s renminbi shock?

Transcription

1 For professional investors 9 September Chi on China What lies beneath China s renminbi shock? Get your facts first, then you can distort them as you please. Mark Twain SUMMARY Contrary to conventional wisdom, devaluation was not the motive behind Beijing s decision to change the renminbi s daily fixing mechanism in August this year because currency devaluation does not help resolve China s economic growth problems in the new normal environment. The renminbi would have to be devalued massively (by up to 40%) against the US dollar, according to our estimate, if it were to generate some marginal benefit for China s exports and GDP growth momentum. This is an unacceptable situation as it would cause a global financial shock. The change is a policy shift in breaking the renminbi away from the US dollar s dominance by making the renminbi more market-driven. This is part of China s structural reform as capital account liberalisation forces a major overhaul of China s economic and policy frameworks. The People s Bank of China (PBoC) surprised the markets on 11 August by changing its daily fixing mechanism suddenly, which led to a 3%+ devaluation of the renminbi against the US dollar. The fixing has since been based on the previous day s average market closing rate quoted from the China Foreign Exchange Trading System 1 (CFETS), instead of on the moving average closing rates of the past 10 trading 1 The onshore foreign exchange market made up by 35 large banks designated by the monetary authorities.

2 What lies beneath China s renminbi shock? 9 September days, as in the old system. The PBoC retains the discretion to adjust the ultimate fixing according to market demand and supply conditions. Devaluation is not the motive The conventional wisdom for such a move was devaluation, under the guise of FX reform, to boost exports and, hence, economic growth. This is unlikely, in my view. Firstly, China s economic weakness may not be as dire as many observers think, even though industrial output, electricity consumption, freight volume and demand for raw materials have all grown slower than the 7.0% GDP growth rate. If China s growth situation was so dire, why did Beijing wait until now to make the FX policy shift, and why did it not devalue the renminbi by much more? The fact is that China is making a transition to a new growth model, with the tertiary sector growing faster and now larger than the secondary sector (Charts 1 and 2). Expanding demand for services, such as health care, education, tourism, entertainment and financial products, is less dependent on expanding industrial output, investment and exports, and less demanding for power consumption, raw materials and freight. Hence, these traditional macroeconomic output indicators are giving a distorted picture of China s growth.

3 What lies beneath China s renminbi shock? 9 September More crucially, devaluation is not an effective tool for boosting Chinese exports and, hence, GDP growth. We ran a regression on China s export growth using the renminbi exchange rate and global demand (as approximated by European and the US industrial output growth) as the explanatory variables (see Table). The evidence shows that the predominant factor affecting Chinese export growth is global demand, not the exchange rate. Further, the impact of global demand on Chinese export growth is 20 times bigger than the exchange rate impact. In other words, China s exports do not need a cheap renminbi; indeed China s exports have continued to gain global market share despite the steady rise in the renminbi s trade-weighted exchange rate since the 1990s (Chart 3). If devaluation were to give Chinese exports a competitive boost, our estimate shows that the renminbi would have to be devalued against the US dollar on a sustained basis by 20% to 40%, depending on the currency-weight assumptions one uses. This would potentially create an unacceptable global financial shock. Ultimately, it is the GDP growth impact of currency devaluation that counts. Evidence shows that China s net exports have not been contributing to GDP growth since 2009; they have actually been a drag (negative contribution) on growth (Chart 4). Impact of RMB exchange rate movement and G2 demand growth on Chinese exports X t = ß 0 + ß 1 RMB t + ß 2 IP t + e t where X t = China's export growth RMB t = RMB/USD exchange rate %YoY change IP t = US and EU's industrial output growth OLS regression results: coefficient t-stats Intercept (ß 0 ) Adjusted R-squared: 0.52 RMB/USD %YoY (ß 1 ) Observations: 179 EU+ US IP growth (ß 2 ) Experiment with different (2 to 3 month) lags yielded similar results, but with the wrong signs for the RMB coefficient Data sources: CEIC (IMF), BNPP IP (Asia)

4 What lies beneath China s renminbi shock? 9 September Meanwhile, the costs of a large devaluation would likely create a devaluation expectation spiral, generating destabilising capital outflows from China and worsening the financial burden on Chinese firms that had borrowed unhedged in US dollar (this debt, which includes their borrowing in Hong Kong dollars, is estimated at USD480 billion or more than 4% of GDP as of H1 2015). These risks could potentially become systemic. In short, the expected benefits of devaluation are marginal and uncertain but the expected costs are substantial and imminent. Devaluation is not a worthwhile strategy. It s all about reform Rather, the move to change the daily fixing mechanism is a step towards renminbi liberalisation as China moves towards the Impossible Trinity paradigm, where the opening of China s capital account is forcing it to choose between retaining monetary autonomy (or controlling the interest rate) and controlling the exchange rate. Clearly, Beijing is choosing to retain monetary autonomy by letting go of the exchange rate. This is the preferred choice because China s large continental economy will allow it to conduct more effective monetary policy than small open economies, such as Hong Kong and Singapore, where international factors often overwhelm the influence of domestic monetary policy. This means that opening the capital account, or the advent of Impossible Trinity, is forcing China to pursue a major overhaul of its economic, financial and policy frameworks. Beijing s move to reform the fixing regime is another step to making that change. It also has a strategic goal of boosting the likelihood of the renminbi becoming a reserve currency by directly addressing the IMF s concern about the renminbi s inconvertibility. Beijing is campaigning for adding the renminbi to the currency basket that forms the IMF s Special Drawing Rights (SDR), which is a fast-track for the renminbi to become a reserve currency 2. The ultimate importance of the SDR for China is that it is a signpost for China s capital account liberalisation and, hence, structural reform progress. Assuming China follows through on its pledge to open the renminbi to market forces, it can credibly claim that its currency is freely usable, which is a condition for a currency being included in the SDR basket. And once the renminbi becomes an SDR component, Beijing can use that status as an external force to push for 2 See Chi on China: SDR A Reserve Currency Fast-Track for the Renminbi, 1 April 2015.

5 What lies beneath China s renminbi shock? 9 September more structural changes, just as it did by using its World Trade Organisation membership to force reform in the state sector in the early 2000s. The IMF trigger The IMF staff report 3 in early August highlighted that a more market-based valuation of the renminbi rate against the US dollar would be needed as a key factor for considering the renminbi s inclusion in the SDR basket. This could well have been the trigger for Beijing changing the renminbi fixing regime on 11 August. If the renminbi is to become a reserve currency, it must be priced in its own rights rather than simply being a minion of the US dollar. Beijing s reform of the renminbi fixing regime shows it believes it is time to sever the renminbi s tie with the US dollar. Arguably, this is a statement of confidence rather than a sign of weakness. Chi Lo Senior Economist, BNPP IP 3 Review of the Method of the Valuation of the SDR Initial Considerations, International Monetary Fund, 4 August 2015.

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