China's Devaluation: More to Come?

An analysis by Michael Lelyveld
2015-09-08
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A Chinese clerk counts yuan banknotes at a bank in Nantong, east China's Jiangsu province, July 22, 2015.
A Chinese clerk counts yuan banknotes at a bank in Nantong, east China's Jiangsu province, July 22, 2015.
ImagineChina

Nearly a month after China's devaluation rattled world markets, doubts about the country's currency policy remain unresolved.

On Aug. 11, the People's Bank of China (PBOC) caught investors off guard with a 1.83-percent devaluation of the yuan against the U.S. dollar, pushing the currency to its largest one-day drop since 1994.

The PBOC explained the move as a "one-off" adjustment to bring its central parity rate closer to market trading, promising that its daily fixings would be more "market oriented" from now on.

Under China's foreign exchange policy, the central bank has allowed the yuan's value to vary in onshore trading from a daily fixing within a 2-percent band, but the market had been pulling the currency toward the weak side of the corridor for months.

The sudden policy shift upset foreign markets and sparked warnings of a global currency war, but it won praise from some economists who saw it as an attempt to loosen controls and give the market more scope in China's foreign exchange.

The step was also seen as a bid for global acceptance of the yuan by increasing its eligibility for inclusion in the International Monetary Fund's currency basket for Special Drawing Rights (SDR), a virtual denomination for lending based on the dollar, the euro, Britain's pound and the Japanese yen.

On Aug. 12, the IMF called China's currency move "a welcome step as it should allow market forces to have a greater role in determining the exchange rate."

The positive comment was largely drowned out by concerns that the devaluation was part of plan to boost exports by making them cheaper abroad.

One argument in support of that view is that the devaluation came just three days after the General Administration of Customs (GAC) announced that exports fell
0.9 percent in yuan terms in the first seven months of the year with an 8.9-percent plunge in July, the steepest in memory.

In new trade figures for August announced today, exports have continued to slump, sliding 6.1 percent from a year earlier. The dip in exports so far this year deepened to 1.6 percent as August imports fell 14.3 percent. Year-to-date imports were down 14.6 percent.

True state of China’s economy

The debate over motives for the devaluation grew louder as the yuan continued to fall in trading after Aug. 11, suggesting that the “one-off” adjustment would be more than a one-day event.

Worries turned quickly from motives to concerns that the moves were a measure of the true state of China's economy, which is suspected as being weaker than the official 7-percent growth of gross domestic product (GDP).

"The yuan's devaluation was certainly a catalyst as it aggravated concerns about China's weakening economy," Chaoping Zhu, an economist at UOB Kay Hian Holdings in Singapore, told The Wall Street Journal on Aug. 25, a day when the Shanghai Composite Index fell 7.6 percent.

Fears that the economy is weaker than reported have had an echo effect, since they add pressure on the yuan in market trading while suggesting that the PBOC also wants it to come down, but at a more controlled pace.

In the first week, the PBOC pushed back against the market with interventions after devaluation topped 4 percent, trimming the adjustment to less than 3 percent.

On Aug. 25, Premier Li Keqiang tried to send a reassuring signal that "there exists no basis for continued depreciation," state media reported. But trading within the band kept dragging the yuan down, pressuring the PBOC to prop it up with dollar sales, costing U.S. $93.9 billion last month.

Following Li's statement, the yuan's value in daily fixings continued to fall for two days, raising further questions about the government's credibility and its policy role. On the third trading day, the PBOC strengthened the daily guidance rate, catching markets off guard.

In subsequent sessions, the yuan has gradually gained amid speculation that President Xi Jinping may have sought to avoid arguments over currency manipulation before his visit to the United States this month.

On Sept. 1, the PBOC also issued new rules to discourage speculation on the yuan's future value by trading in instruments known as currency forwards, to take effect on Oct. 15.

Defending the yuan


The PBOC has spent heavily to defend the yuan since Li's statement. On Monday, the central bank said that its foreign exchange reserves fell by U.S. $93.9 billion last month to U.S. $3.56 trillion.

But in the 15-day period between the pre-devaluation market session of Aug. 10 and Li's statement, the yuan central parity rate dropped by about 4.4 percent.

While larger than the initial "one-off" devaluation, the relatively modest change has been cited as evidence that the PBOC never intended its policy reform to be part of an export promotion plan.

In one of several postings at the Peterson Institute for International Economics, China economist Nicholas Lardy argued that devaluation would have to be much greater to give exports a kick.

"Depreciation is not likely to buy much growth unless it exceeds 10 percent on a sustained basis," he said.

Lardy used the reasoning as part of a larger response to doubts about China's economic growth claims, arguing that "skeptics of China's GDP growth have not made their case."

"Why didn't the authorities devalue by a much larger amount?" he asked, concluding that the PBOC move was designed to meet IMF recommendations, not to boost exports or GDP.

Gary Jefferson, a China specialist and Brandeis University professor of trade and finance, agrees that "a 4-percent devaluation is not going to make much of a difference."

On the other hand, Jefferson said in an interview, China's leaders might not have made the decision to devalue even that much if they had foreseen how much reaction it caused.

"The disruption to the global economy clearly is going to be more depressing with respect to China's export performance had they not enabled the depreciation of the currency," he said.

In the end, the devaluation failed to achieve either objective.

Leaving the basket unchanged

On Aug. 19, the IMF said it would leave its SDR basket unchanged until at least Sept. 30, 2016, a decision reflecting the judgment that the yuan is still not a freely traded currency.

But battles over confidence in China's currency, its stock market, its economy and its statistics continued to rage as the government turned from exchange rates to monetary measures with cuts in interest rates and the reserve requirement ratio for banks on Aug. 25.

The differences played out the next day in the pages of The New York Times as Lardy argued in an op-ed that there was "little evidence that China's economy is slowing significantly" from the official 7-percent growth rate.

“Nobody believes China's official statistics anyway,” economics columnist Eduardo Porter wrote in the paper's business section on the same day as Shanghai stocks continued to fall.

While China-watchers have had these debates for years, world attention came suddenly into focus after the Dow Jones Industrial Average dropped more than 10 percent in four days and losses spread through global markets.

The sudden rise in doubts about China provided the spark for the stampede, but there is still little agreement on the state of China's economy, its regulatory responses or their adequacy to maintain stability.

Also, there has been little consensus on the reasons for China's measures and whether they will be repeated.

Although the rate cuts were widely seen as aimed at encouraging the stock market, some analysts note that the move was driven by the devaluation, which led to a short-term liquidity squeeze.

"The PBOC's reserve requirement ratio cut cannot make up for the loss of liquidity resulting from the yuan's depreciation," China Woon Khien, a portfolio manager at Nikko Asset Management in Shanghai, told Bloomberg News.

A distinction may also be drawn between the results of China's measures and the motivations.

Yukon Huang, senior associate at the Carnegie Endowment for International Peace and a former World Bank country director for China, said the devaluation was meant to reflect the IMF recommendation and narrow the gap with other Asian currencies that had already depreciated by larger amounts.

But it was also promoted as an export remedy "to secure senior leadership's approval," Huang said in an email message.

In any case, "exchange rate changes have a limited impact when the problem is stagnant global demand," he said.

"Thus, even a larger change will not have an impact on export volumes, but exporting firms will experience improvements in profitability," Huang said.

For all the fuss about the devaluation, there could still be more to come over time under the new market-driven policy for daily adjustments.

"It may yet turn out to be a 10-percent or larger devaluation," said Jefferson.

Although the yuan has firmed and stabilized in recent sessions, some economists expect depreciation to resume after Xi's visit.

On Friday, PBOC Deputy Governor Yi Gang voiced confidence that the currency "will be more or less stable around the equilibrium level," Bloomberg reported. But a Reuters survey found that economists believe the yuan will fall by another 2 percent over the next six months.

If there is an effect on exports, China's exporters might not feel it until next year.

"I would imagine something closer to six months than six weeks would be needed in order for a change to become apparent," Jefferson said.

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