China’s exchange rate policy has led to much angst and confusion across global markets over recent months. To their credit, the Chinese authorities have claimed they will try to maintain a “stable” value for Yuan against a basket of currencies this year. The problem, however, is that the Chinese real exchange rate is already uncomfortably high, and China is battling to contain speculative capital outflows due to (the probably correct) expectations that a major currency devaluation seems inevitable. Were China to undertake a large one-off devaluation, the shock would likely unleash a tidal wave of investor uncertainty across global markets, including our own little part of the world down here in Australia.
China’s Real Exchange Rate is Historically High
As seen in the chart below, China’s real exchange rate index has appreciated strongly in recent years and is now at relatively high historic levels.
The Yuan’s strength since 2005 at first reflected deliberate revaluation against a weaker US dollar, which in turn reflected both efforts to contain local Chinese inflation as well as pressure from the US Government on trade competitiveness grounds. Between 2011 and early 2014, the Yuan continued to be revalued, moreover, even against a now strengthening US dollar. With acceleration in US dollar strength since 2014, the Yuan has then been gradually devalued against it – though not by enough to stop the overall real Chinese exchange rate continuing to rise.
On some measures, the recent appreciation of the real Chinese exchange rate corrected for an extended period in which it was kept artificially cheap. Indeed, according to The Economist Magazine’s Adjusted Big Mac Index, the Chinese Yuan was still 9.4% undervalued in January. On an outright purchasing power parity basis, the currency is estimated to be as much as 40% undervalued.
That said, the fact remains that for local Chinese business, relative competitiveness is a lot worse than what they have been accustomed to in recent years, and this likely helps explain the curtailment in Chinese trade and industrial production growth in recent years. China’s balance of payments surplus, for example, has shrunk from around 10% of GDP in 2007, to around 2.7% in 2015.
What’s more, Chinese residents themselves don’t appear to believe their own Government, with large private capital outflows contributing to a $US513 billion decline in foreign currency reserves last year. As even the Reserve Bank of Australia noted in its February Statement on Monetary Policy, “it is likely to be difficult to maintain stability of the RMB, given the magnitude of private capital outflows”.
If the response of global financial markets to China’s August 2015 devaluation against the US dollar is any indication, a large one-off move by Chinese authorities would be especially destabilising to investor sentiment around the world. At a time of rising military tensions with the United States and cooling in diplomatic relations, however, the Chinese might also come to decide they could live with the likely American outcry.
It will be also difficult for other countries to finger point, given that many central banks around the world are actively pursuing a “beggar thy neighbour” cheap currency strategy through quantitative easing programs and even negative official interest rates.
If China does act it would signify a new intensification of so-called global currency wars. To my mind, this is a very real risk heading into 2016 and another reason why it might be prudent for investors to adopt a cautious attitude to risk assets or perhaps consider investments with in-built risk management strategies.