China's currency is falling. The renminbi (RMB) posted its biggest ever monthly fall against the U.S. dollar in June, and hit a 19-month low on Aug. 15.
Some commentators believe that the Chinese authorities have used currency weakness to open another front in the trade war against the United States. In the first seven months of 2018, despite new tariffs on Chinese goods introduced by President Trump, China's trade surplus with the U.S. increased by 12.9 percent year-on-year to S162 billion at the end of July.
Call It a Comeback
These summertime blues for the RMB may prove to be short-lived, however. Emerging market (EM) currencies, including some of China's big trading partners in Asia, are having a torrid time in 2018. In the first half of the year the RMB was a stable safe-haven. A mark-to-market catch up was arguably overdue.
China has also been experiencing an economic slowdown. After unprecedented fiscal stimulus equivalent to 12.5 percent of GDP in the aftermath of the global financial crisis in 2008, the government is now trying to engineer a managed deleveraging for the municipal governments and state-owned enterprises that the fiscal largesse was directed to. It is loosening monetary conditions, principally by relaxing bank reserve requirements, to smooth the process.
De Facto Reserve Currency
Though Chinese growth has stayed comfortably above 6 percent, forward looking indicators such as the manufacturing PMI are turning down. U.S. growth is accelerating and monetary policy is tightening. Fed fund futures point to a high likelihood of the Federal Reserve raising rates at its December meeting. The positive carry from owning RMB versus U.S. dollars has fallen.
However, the big picture remains the same. In October 2016, China joined the special drawing rights (SDR) basket of the International Monetary Fund (IMF) with a weight of 10.9 percent. This conferred on the RMB de facto reserve currency status. This is a prize China fought long and hard for and will not risk by being criticized as a currency manipulator.
Weak Currency = Instability
A weak RMB does not sit well with China's long-term policy goals. After the financial crisis, the Chinese were quick to realize that their export-driven, mercantilist growth model was no longer fit for purpose. A debt crisis in the West meant that demand for Chinese goods was becoming sated. The authorities have shifted their focus from exports and investment to domestic consumption to keep growth on track. Consumption now accounts for 60 percent of GDP growth.
China already runs a current account deficit with the world, with the exceptions of the U.S. and eurozone. Above all else, Chinese authorities value macroeconomic stability. A weak RMB threatens instability via two channels. First, during the last period of RMB weakness in 2015-2016 China experienced significant capital flight.
Though the capital account is still not fully open, it is porous enough to give sophisticated investors a way out of a depreciating currency. Secondly, a weak currency can import inflation, particularly in an economy that is shifting toward running current account deficits. Chinese inflation has averaged just 2.35 percent over the past decade.
Entering the Bond Market
In the long term, China will need to fund its current account deficit via the bond market. The opening of the interbank bond market to foreign investors in 2016 and the ability to trade via Bond Connect in Hong Kong since 2017, demonstrates an awareness of how important overseas funding will be.
Chinese Government Bonds will be included in the Bloomberg Barclays Aggregate index from April 2019. China's inclusion in bond indices is a further step toward its integration into the global financial system and will help cement the RMB's role as a reserve currency in global portfolios. Foreign investors do not like to see their bond returns damaged by currency instability. Price rises scare authoritarian regimes that derive their legitimacy from delivering on growth and macroeconomic stability.
Despite talk of trade wars there is little incentive for China to see the RMB weaken further. It has $3.1 trillion in foreign exchange reserves and Yi Gang, governor of the People's Bank of China, has said China will "keep the yuan exchange rate basically stable at reasonable and balanced level." As China looks to burnish its reserve currency status and attract international portfolio flows into its bond markets, intervention becomes increasingly likely.
Written by Andrew Capon. Read more from the author here.