By John Richardson
THE above chart further illustrates the dilemma confronting China, which, despite the often-discussed and wrongly interpreted growth in its domestic consumption, still depends on exports for about a quarter of its GDP.
Based on Bank of International Settlements (BIS) data, and compiled by the Federal Reserve Bank of St Louis, the chart shows that:
- China’s real effective exchange rate has increased by 26% over the last four years. This “real effective exchange rate” is an inflation-adjusted trade-weighted average of the Yuan’s value against a cross–section of the currencies of its trading partners.
BIS analysis also shows that China’s currency has appreciated more than any of the other 60 countries in the organisation’s coverage over the last four years, with the exception of Venezuela. And Venezuela should be discounted because its figures are distorted by multiple currency regimes.
“This currency shift is, of course, the functional equivalent of a large hike in the price of Chinese exports. Add to that continued sluggishness in global demand, and the once-powerful Chinese export machine is suffering, with total exports down by 3% year-on-year in January,” writes Stephen Roach, former chairman of Morgan Stanley Asia and now a senior lecturer at Yale’s School of Management.
Stephen Roach, however, then argues that China will not respond through a competitive devaluation of the Yuan because:
- This would undermine economic reform, which includes a shift from export-led to consumer-led growth.
- A shift to currency depreciation would inflame anti-China sentiment amongst trading partners, most importantly the US. Tensions with the US are already on the increase following last month’s decision by Congress to introduce the Currency Undervaluation Investigation Act. This would treat currency undervaluation as a subsidy, thus allowing US companies to seek countervailing, or anti-subsidy, duties on imports.
- There would be a “race to the bottom” if China joined in a global currency war, which is already well underway following recent sharp depreciations of the Euro, the Japanese Yen, the Russian Rouble, the Indian Rupee and other currencies.
Reasonable people can disagree and this disagreement is important – and must be taken on board by chemicals companies as they build their scenarios for the rest of this year and beyond. We are no longer living in a “one scenario world”.
I agree that in ideal circumstances, China would not want to devalue the Yuan, but these are not ideal circumstances.
Yes, it wants to rebalance its economy, and is making huge efforts to achieve this objective. But if it is to effectively push-through painful reforms, it has to keep enough people on board – and it will not be able to keep enough people on board if unemployment gets out of control. The reforms are placing a lot of downward pressure on employment and so China needs to release the escape value by weakening the Yuan.
I also maintain that the unwinding of China’s “carry trade” could by itself be enough to force a currency devaluation.
As capital flight from China gathers pace, I think that this unwinding is now well underway.
Here is a reminder of how the process will work, from James Gruber, the Melbourne, Australia-based financial journalist and former fund manager.
Initially, we suspect that China would try to defend the currency by liquidating foreign exchange reserves. That would risk a deflationary spiral, however. It would shrink money supply, reduce credit growth, leading to falling asset prices and further capital flight.
Remember that this strategy was pursued initially by the Asian tigers in 1997. It was abandoned as it proved too painful. Devaluation was eventually favoured and the Tiger currencies declined close to 60% on average.
If capital flight were to occur, we believe China would eventually follow the less-painful route of devaluation too.
Returning to the issue of the pressure on China’s exports from both a stronger currency and a weakening global economy, the HSBC China flash Purchasing Manager’s Index for February showed that export orders contracted at their fastest rate in 20 months.