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Yuan / Renminbi: Will the risk increase?

12/04/2017

Next year in 2018, China will celebrate the 40th anniversary of its "four modernisations" policy that transformed the country from under-achieving centrally planned economy to today's "socialist free market" powerhouse.

These liberalisation reforms precluded China's astronomic growth in recent years, with annual rates often pushing past 10%.   Exports have largely been the engine behind this performance, with low labour costs and lax regulations providing the fuel to steam past global competitors; particularly those based in the West.

The People's Bank of China (PBOC) further 'monetised' central growth plans by consistently utilising a currency devaluation policy.  

In 1981, one USD bought 1.53 yuan (also referred to as the renminbi or CNY).  By 1993, that same dollar bought 8.77 CNY or 6-times less than just 11 years earlier.

As of this writing (March 2017), 1 USD buys 6.85 CNY.  Compared to 2014 where 1 USD bought 6.00 CNY, the currency has lost 12.5% of its value in three years.  Accompanying this decline in currency value has been a cooling in overall growth; with the economy growing at its slowest pace in 26 years, in turn undermining the confidence of international investors in the currency pair; now at its lowest point in eight years.

China's tremendous potential has undoubtedly attracted many foreign investors.  With tens of billions of dollars invested in China, with investors expect their full return on investment based on a strong economy and favourable exchange rates.  However, with the yuan in decline, investors – and their money – are fleeing, leaving China short of badly-needed foreign direct investment.

Growth driven by exports, followed by investment

For years, China needed an undervalued yuan to sustain the country's aggressive modernisation.  Today, this is no longer the case.  China now needs a strong renminbi to, not attract foreign investment, at least to stop the outflow of capital.

In the past, China accumulated massive amounts of foreign exchange reserves – in part due to their long-standing trade surpluses.   Today, though, these reserves are mostly earmarked for PBOC to make currency interventions.  Daily PBOC sells off currency holdings to support the yuan.  As a result, China's FX reserves fell from a peak of 4 trillion USD in June 2014 to 2.81 trillion USD by the end of January 2017; representing an overall 30% decline.

This steady drop is beginning to worry some analysts because, at the current rate, PBOC will extinguish their reserves within the next decade. While the government may set up new regulatory constraints to combat capital outflows, the yuan is currently failing to recover. In this sense, China is virtually disarmed in the struggle to save its currency.

Paradoxically, the new US administration accuses China of manipulating its currency to boost its exports, when in fact, it spends billions of dollars to support it.  If China were to stop doing so, the yuan could face a brutal devaluation.

The difficult (if not impossible) control of the exchange rate

How can China get out of this downward spiral? If it stops its interventions, the yuan risks collapsing, causing, on the one hand, international investors to panic, and on the other, the anger of the Trump administration ready to initiate a foreign exchange war (not to mention the looming threat of trade retaliations via tariffs).  It's important to remember that the US is the world's largest consumer of Chinese exports.  If PBOC continues its intervention, they will squander their foreign exchange reserves without achieving their aims because, as history tells us, central bank intrusions rarely if ever have any long-term impact.

In 2016, China already indicated that it would defend itself versus a basket of currencies in general and against the USD in particular.  Would then, could happen if China decides to let the CNY officially float?  This action could indeed become a reality. In doing so, China would shield itself from US accusations of exchange rate manipulation.   In the immediate short-term, the yuan would more than likely significantly depreciate, eventually stabilising out in the medium term.  Additionally, international investors would be more receptive to participate with a freely tradable currency.  Still, putting this sort of policy in place would be a difficult pill to swallow for a group of leaders more culturally accustomed to having more centralised control.

Persistent volatility in rates

If there is one thing for certain, it's the total uncertainty on the evolution of the Chinese currency against euro or US dollar. For both importers and exporters, it is imperative, in this context, to cover their CNY exposures as soon as possible. Fortunately, the market offers hedging opportunities through the offshore yuan listed in Hong Kong (CNH) against the major currencies (EUR, USD, CHF, GBP, JPY0), which has an excellent correlation with the latter below).

Historique des parités CNY et CNH contre USD


12/04/2017