In order to calm the anxiety of foreign currency traders and hopefully reverse prevailing market expectations, China’s President Xi Jinping reiterated during his state visit to the US last month that there was no basis for long run depreciation of the yuan.
Surprisingly, the yuan then rallied to 6.34 per dollar in the offshore market last week and to even higher levels in onshore market. Extensive intervention by the People’s Bank of China (PBoC) was rumoured to be behind the unexpected rally.
It is estimated that the PBoC has spent almost $100bn to defend the currency since it was devalued by 4% in August. But is further depreciation of the yuan really harmful to the Chinese economy?
The economy grew by 7% in the first half of 2015, the lowest rate of growth since 2000. The “new normal” might explain the relatively low growth but on the other hand, demand side analysis suggests that the substantial deterioration of export growth is largely responsible for China’s significant economic slowdown.
Exports used to contribute more than a third of China’s growth but in the first half of 2015, the engine of exports ran out of steam completely and grew by a mere 1%.
Most China watchers blame sluggish external demand for this disappointing export growth. Examining the structure of China’s exports, however, tells a different story.
In the first half of 2015, ordinary exports actually showed a very healthy growth of 6.7%. By contrast, pure assembly exports and mixed-assembly exports fell by 8.1% and 7.4% respectively, thereby pulling down overall growth.
weaker competitiveness
Since the yuan is basically pegged to the US dollar, the sharp depreciation of other currencies such as the Japanese yen and euro against the dollar in recent years has automatically triggered appreciation of the yuan against all these currencies,
This has further eroded China’s competitiveness as the chief assembly centre of the global manufacturing industry, and has resulted in an exodus of export-oriented foreign investors from China.
Japanese direct investment, one of the largest foreign direct investment (FDI) sources in China, has decreased substantially in the last two years and meanwhile ASEAN countries have replaced China as the top destination of Japanese FDI in Asia.
Consumption, investment and exports have been the three pillars supporting the growth of China’s economy in recent decades. Given the significance of exports, it is highly unlikely that the moderate growth of domestic consumption would be able to compensate for reduced exports in the short-run. Moreover, the rebalancing argument simply focuses on the adjustment of demand side and ignores the rigid structure of supply, where excess capacity may not be absorbed automatically by an increase in domestic demand. Hence, rebalancing the economy from export-oriented to domestic consumption oriented is easier said than done.
China should let the yuan depreciate as the market expects so as to revitalise the growth of exports, thus strengthening its growth prospects, which is vital for both the domestic and global economy.
Profit margins
Depreciation of the yuan will have little impact on the prices of China’s exports, but it will increase the profit margin of exporting firms, especially firms engaging in assembly exports with razor-thin profit margins. The profit increase associated with the depreciation will stimulate the expansion of exports and provide an additional support to the growth of the economy.
Further depreciation of the yuan may undercut the probability that the yuan would be included in the basket of the special drawing right (SDR), and delay the process of the internationalisation of the yuan. SDR status, however, is purely symbolic and cannot guarantee the yuan would be an acceptable reserve currency by the global community.
The success of the yuan’s internationalisation is eventually determined by the stability of the economy. Exchange rate policy is an integral part of monetary policy, which should ensure stable economic growth. Economic growth should be given higher priority than other objectives in deciding the direction of exchange rate policy.
Additionally, fixing the exchange rate of the yuan within a narrow band is not only costly, but also undermines the effectiveness of China’s monetary policy. To boost the growth of the economy and stabilise the volatile stock market, the PBoC has cut interest rates and lowered reserve ratios a few times. All of these policy actions would be eventually sterilised by the central bank’s active interventions in the foreign exchange market.
Letting the yuan follow the market and depreciate, will not only free China from the trilemma, but more importantly give a desperately needed boost to economic growth.
Yuqing Xing is professor of economics at the National Graduate Institute for Policy Studies in Tokyo and former director of the department of capacity building and training at the Asian Development Bank Institute.