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Financial markets have experienced a meltdown since the beginning of the year. The decline impacted all risky assets, including global equities (down 7.9% in the first three full trading weeks of the year), emerging markets’ bonds and currencies (1.2% and 3.0% respectively) as well as commodities (6.9%). Just like August last year, the turmoil was triggered by a devaluation of the Chinese currency, which fell by 1.6% against the US dollar in the first week of the year. Although the yuan has subsequently stabilised, markets have remained nervous about the uncertainty surrounding China’s exchange rate policy. The question is whether the Chinese authorities can manage a gradual devaluation that is beneficial for the economy, or if devaluation will be chaotic with negative economic implications.

A gradual devaluation of the currency could be beneficial for three main reasons. First, it would help exporters, boosting economic growth. Until recently, the Chinese yuan was closely linked to the US dollar. Expectations of tighter monetary policy in the US relative to the rest of the world have led to the appreciation of the dollar against most currencies. This has pulled up the value of the yuan, leading to its rise against most currencies. On a trade-weighted basis, the yuan has strengthened by 20% since 2012. This has hurt exports and, in turn, growth. The Chinese economy’s 2015 growth was the slowest in 25 years, with real GDP expanding by only 6.9%. A devaluation of the yuan could restore some of the lost competitiveness to Chinese exports, and invigorate growth in the future.

Second, a devaluation of the currency could reduce the need to sell foreign currency reserves to support the yuan. Chinese reserves declined by over USD100bn in December 2015, and by a total of USD700bn since their mid-2014 peak. This happened as the authorities tried to support the currency in the face of capital flight. And while China still possesses considerable reserves amounting to USD3.3tn, these could be depleted if capital flight continues at the current rate. Allowing more flexibility in the exchange rate may help preserve China’s reserves.

Third, a more flexible exchange rate would also reflect the new requirements for a more liberalised currency following the International Monetary Fund’s decision to include the yuan in its Special Drawing Rights basket, supporting the goal of the authorities to internationalise the currency.

Chinese yuan trade-weighted exchange rate

(index)

 

Chinese yuan trade-weighted exchange rate

Sources: JP Morgan and QNB Economics

However, the devaluation of the currency also comes with its own set of risks. Chief among them is the risk of widespread corporate defaults. China has accumulated nearly USD1.5tn of foreign-currency debt over the last eight years. A devaluation of the currency would make servicing this debt more burdensome, which could result in a financial crisis that could bring the economy down.

Second, a devaluation could be interpreted as a sign of an underlying weakness in the Chinese economy. This could lead to continued turmoil in financial markets with negative repercussions in China and the rest of the world, given China’s size in the global economy, its contribution to the world’s economic growth, its dominant role in trade and its importance as a major consumer of commodities.

Finally, a devaluation could delay China’s planned transition towards a more consumer-based economy. A significant weakening of the currency would make imports more expensive, reducing the purchasing power of consumers.

The risk-benefit analysis of China’s devaluation outlined above suggests that a small, controlled devaluation could benefit Chinese exports and growth. But this needs to be done without triggering a large devaluation or a currency crisis in China with unpredictable repercussions. When it comes to the fate of their exchange rate, the Chinese authorities do not have much room for manoeuvre.


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