Published 28 May 2024
China recently signaled its willingness to let the renminbi weaken against a strengthening dollar. Such a move would likely aggravate capital flight from the country and global trade tensions by making Chinese exports cheaper.
China’s exports face multiple headwinds. Growing resistance in developed countries and some developing countries to accommodating a surge of exports from excess production mean protectionist policies are on the rise worldwide. China’s exporters are likely to face higher tariffs and greater restrictions to their market access in years to come.
Compounding these headwinds, China this month signaled its willingness to let its currency, the renminbi (RMB), weaken against a strengthening dollar. The move is reflected in the Chinese central bank’s daily fixing of the RMB, also called the yuan. Last week, the People’s Bank of China set the yuan’s daily reference rate at its lowest level since January, indicating a reversal of a long-held policy of holding the reference rate steady as an anchor for regional currency stability, part of its efforts to create greater international stature for the yuan.
The clues points to a deliberate devaluation of the RMB. Such a pattern would likely exacerbate global trade tensions by artificially making Chinese exports cheaper and inducing other governments to take up similar policy responses.
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China’s quandary is a peculiar one. Superficially, the RMB looks as though it ought to be rock-solid. Its current account is running at a healthy surplus. China has a positive net international investment position to the tune of US$2.9 trillion, meaning China owns more overseas assets than foreigners own assets in China. In addition, according to the World Bank, the RMB is 40% undervalued on a purchasing power parity (PPP) basis. Furthermore, China’s lead in the output of key products associated with climate transition suggests that its exports will continue to be in strong demand anyway, going forward.
It is, therefore, odd to suggest that the RMB looks vulnerable to devaluation, whether it’s planned or otherwise. China’s currency appears well underpinned.
Geopolitical and geoeconomic considerations, however, when combined with China’s non-market approach to growing its political economy, mean such analysis may not be correct.
China’s current account has in fact been shrinking. In 2023, according to China’s State Administration of Foreign Exchange (SAFE), the merchandise trade surplus was US$594 billion, vastly offsetting a services deficit of US$207 billion. However, it is worth noting that China’s 2023 current account surplus was 43% smaller than in 2022, when it came in at US$443 billion. This rapid deterioration was driven by a large expansion in the services deficit (up 138% from just US$87 billion in 2022) and a reduction in the goods surplus (down 11% from US$665 billion in 2022). In the first quarter of 2024, the current account surplus was US$39 billion, down 50% from the first quarter in 2023 and down 60% from the first quarter in 2022.
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As the chart below shows, on a four-quarter moving average basis, the current account surplus in nominal dollar terms is now the smallest it has been since the fourth quarter of 2020.
China’s dependence on exporting its way out of domestic economic morass is at greater risk than it first appears. Measures such as the European Union’s Carbon Border Adjustment Mechanism (CBAM), aimed at reducing the carbon intensity of global industrial production by taxing embedded emissions at point of origin, could hit China’s exports harder than those of other countries.
The above factors, along with China’s chronically weak domestic consumption, collapsed property market, and rising demographic cost at home, are inducing Chinese exporters to move offshore. This is reducing the value added that takes place in China and replacing export earnings with profit streams from overseas. These have so far been modest.
The rapid and large fall in the Japanese yen over the past two years could alter the attractiveness of Japanese exports relative to China. Those with long memories will remember that yen weakness from 1995 was the catalyst for Asian currency devaluations during the Asian financial crisis, as Japan took market share in exports and accelerated the deterioration in regional current account balances.
Although China’s current account remains in robust surplus, albeit shrinking, the expected foreign currency inflows associated with such a surplus are not necessarily materializing.
Exports have been the main way in which China has been able to amass US dollars. Increasingly, though a greater share of Chinese exports and imports have been settled in RMB. China still needs to earn dollars to pay for those imports that cannot be paid for in RMB, to stem downward pressure on the dollar exchange rate and finance Chinese overseas investment. As more yuan is needed to purchase each dollar, a pattern of Chinese devaluation opens the way for each of these economic problems to reinforce and magnify each other.
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As the chart below shows, foreign currency receipts and payments associated with the current account have significantly underperformed the reported value of the trade surplus.
Whether this difference in foreign exchange earnings compared with reported current account surpluses reflects interest rate differentials or surreptitious capital flight is debatable. The key point is that with the increased use of the RMB in trade payment settlements, it is a mistake to equate exports with foreign currency earnings in a linear fashion as was the case even just a few years ago.
China’s investment- and savings-led growth model has led to a huge accumulation of capital stock: about 5 times the size of China’s gross domestic product or about US$100 trillion. Most of this capital stock is in bank deposits and loans on the other side of the banking system’s balance sheet. As we have analyzed before, the returns on China’s capital stock have declined very significantly in recent decades, indicative of a large misallocation of capital.
Low returns on capital in China are reflected in the fact that despite significantly lower interest rates than the United States, China is facing deflationary pressure. Since the end of 2022, the federal funds rate, the target interest rate set by the US Federal Reserve at which commercial banks borrow and lend their extra reserves, has exceeded the PBoC’s short-term rate. This differential provides a strong incentive to move capital out of China. The barrier is, of course, Chinese capital controls but as the saying goes, “where there is a will, there is a way.” Chinese businesses and individuals have proven adept in the past in bypassing these controls.
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China’s defences against unwanted downward pressure on its currency from capital flight are weakening. Its rising overseas investments cannot be easily liquified to support the exchange rate. Despite growth in China’s total overseas assets controlled by the state, foreign reserves have remained at around US$3.2 trillion, a level reached in 2011. In contrast, liquid RMB-denominated assets held by China’s corporates and households have risen dramatically. M2 alone in April 2024 stood at 301 trillion yuan (US$41 trillion). With reserves at about 3% of the capital stock and 8% of M2, the potential for the PBoC to be overwhelmed by capital flight is very real.
Two things seem to be increasingly evident. Greater international usage of the RMB could erode the Chinese Communist Party-state’s ability to control the value of the yuan. Secondly, capital controls might well need to be tightened in the face of higher returns on capital outside China, especially since Chinese real estate as a store of wealth has collapsed. Perhaps downward pressure on the yuan is ultimately a manifestation of what has gone wrong with China’s economic policy-making: its subjugation of economic considerations to political ones.
© The Hinrich Foundation. See our website Terms and conditions for our copyright and reprint policy. All statements of fact and the views, conclusions and recommendations expressed in this publication are the sole responsibility of the author(s).
Stewart Paterson is a Research Fellow at the Hinrich Foundation who spent 25 years in capital markets as an equity researcher, strategist and fund manager, working for Credit Suisse, CLSA and most recently, as a Partner and Portfolio Manager of Tiburon Partners LLP.
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