Jitters over China's currency, which haunted markets in early 2016, are back -- and it's not just because of Donald Trump.
The yuan (CYB) - Get WisdomTree Chinese Yuan Strategy Fund Report will decline in 2017 for a fourth straight year as authorities tap into the central bank's $2.998 trillion of foreign reserves to recapitalize an ailing banking system, according to a top expert on the country's economy.
Using the reserves to address banks' troubled loans would leave less firepower for the central bank to intervene in currency markets and prevent a steeper slide in the yuan, said Diana Choyleva, chief economist at Enodo Economics in London, who has been covering China for 16 years and wrote a book on the country in 2011.
Such a depreciation would likely rattle global markets: In early 2016, investor anxiety about a possible yuan devaluation sent the Standard & Poor's 500 Index (SPY) - Get SPDR S&P 500 ETF Trust Report down 5.1% in a single month. Since mid-2014, China has burned through almost $1 trillion of its reserves to keep the currency from falling faster. Last month, they fell below the psychologically important threshold of $3 trillion for the first time in almost five years.
"The big difference between 2017 and 2016 is that there'll be a lot more policy action and as a result a lot more volatility, affecting not only China's own markets but having a global impact," Choyleva said in an interview. "The worry about China debt will come back in force, and that is just likely to raise risk aversion."
Anxiety among investors and policymakers over the yuan's trajectory has come into greater focus following Trump's election as U.S. president on pledges to label China a currency manipulator and impose import duties of as much as 45%. The theory is that a cheap currency makes a country's exports less expensive and easier to sell, thus aiding domestic manufacturers -- and workers -- at the expense of trading partners.
While Trump hasn't yet followed through on either of his campaign promises related to trade with China, further currency depreciation could exacerbate tensions between the president and Beijing, triggering additional volatility. The new U.S. administration has already irked Chinese officials by engaging in public dialogue with the leader of Taiwan, which they consider to be a rogue province, and by suggesting that U.S. marine patrols could be stepped up in the disputed waters of the South China Sea.
"The big question mark really is Trump," she said.
Major questions over the Chinese currency emerged in early 2016 when hedge-fund manager Kyle Bass of Hayman Capital predicted authorities would be unable to stave off a steep devaluation -- of more than 30%.
Choyleva predicts that China's "real effective" exchange rate -- one that's adjusted for disparities in the price of goods between different countries -- will decline by about 10% this year.
The Chinese government has allowed the nominal, non-adjusted rate versus the dollar to weaken in each of the past three years, already the longest streak since the early 1990s, according to FactSet data. It's now at about 6.85 per dollar; as recently as 2014, a dollar could be bought for as little as 6.04 yuan. Morgan Stanley (MS) - Get Morgan Stanley (MS) Report and Bank of America (BAC) - Get Bank of America Corp Report predict the rate will end 2017 around 7.3 yuan to the dollar.
"If China doesn't get the safety valve of a weaker currency, then the growth story turns much more negative from next year onward," Choyleva said.
Economic growth in China has decelerated to 6.8% annually from a rate above 12% less than four years ago, saddling the country's banks with an elevated proportion of bad loans. According to S&P, problematic loans will rise this year to almost 7% of the total outstanding. That ratio stood below 4% as recently as 2013, according to the International Monetary Fund.
According to an IMF analysis in April 2016, commercial banks in China could potentially stand to lose $756 billion from corporate loans going sour.
Choyleva, who predicted a slowdown in China's economy as early as 2010 when most economists were still foreseeing rapid growth, expects output to decelerate to roughly 5% this year -- well below the IMF's projection of 6.5%.
One common misconception, according to Choyleva, is that Chinese officials led by President Xi Jinping must wait until the Communist Party's once-every-five-years congress later in 2017 to take major policy actions. Xi already has already consolidated power, and the country's central bank has started taking steps to address financial risks, she said.
"This is already kicking in," she said. "Their efforts to clean up the financial sector will be in full view."