Will China's currency crash the global economy?

As much as $1 trillion has left the country—and the pressure is mounting

January 12, 2016
A currency trader gestures at the foreign exchange dealing room of the Korea Exchange Bank headquarters in Seoul, South Korea, August 2015. ©Ahn Young-joon/PA
A currency trader gestures at the foreign exchange dealing room of the Korea Exchange Bank headquarters in Seoul, South Korea, August 2015. ©Ahn Young-joon/PA

It has fallen about 1 per cent since the beginning of the year, it’s about 2 per cent lower than after a wobble last summer and about 5.5 per cent lower compared with the weeks before that. Most people wouldn’t blink if this was anything but the Chinese currency. But the Yuan has become "hot" again in financial markets, partly because of mounting concern that it might tip the world economy into another global recession.

How could that be, you might ask, if it has moved so little, and especially since the People’s Bank of China, the Chinese central bank, maintains a tight grip on the currency market and on capital flows in—and especially out of—China. As if to prove the point, the central bank intervened in the so-called offshore market in Yuan, known as the CNH market, to stabilise the falling currency by pushing overnight interest rates up to over 13 per cent on Monday, and 68 per cent today. People who had "shorted" the currency would have been well and truly squeezed into submission. For the first time since late last summer, the wide difference between the CNH rate and the on-shore rate, called CNY, was eliminated. Anyone who still believes the Chinese currency system is gradually being liberalised needs to take another look at what just happened.

But what is spooking investors is a quartet of complex uncertainties. First, technical and incremental changes to the management of the exchange rate system since last summer have not succeeded in bolstering confidence in the Yuan, which is reflecting deeper economic and financial concerns.

Second, the People’s Bank of China’s preference for Yuan stability against a broad range of currencies that permits some limited depreciation against a strong US dollar is not a consensus or uncontested view in Beijing. Behind the scenes, some seem to favour a more aggressive decline.

Third, periodic capital flight could make it difficult for the PBC to hold its line. Last week, it was announced that China’s foreign exchange reserves had dropped by over $512bn in 2015. Given that China earned about $600bn from international trade and net foreign direct investment, China may have had about $1 trillion of capital outflows, a high proportion of which was capital flight, related partly to poor economic performance and prospects at home.

Fourth, the possibility at some stage of further but more significant currency depreciation, or even a formal devaluation is likely to remain open. If it happened, this could send shockwaves through the global economy and perhaps even tip it into another recession.

How would this happen?

China is, after all, the world’s biggest trading nation, and accounts for about 13.5-16.5 per cent of world GDP (depending on measurement at market exchange rates, or so-called purchasing power parity, though the former is more relevant). This compares with about 24 per cent for the EU and 23 per cent for the US.

The good news is that the US and EU are large, and relatively closed economic structures that should be relatively protected but not immune from adverse developments in China. The bad news is that most of the other 40 per cent of world GDP is accounted for by emerging markets and developing countries, the most important of which have already lapsed into an economic growth hiatus of unknown duration. One important contributor has been China’s slowdown has already manifested itself in a major reversal in commodity prices that has torpedoed commodity-dependent economies in Latin America, Africa and Australasia. Weakness and instability in the largest emerging countries would clearly have negative consequences for the earnings and prospects of many Western companies.

A larger Yuan depreciation or devaluation would also exacerbate these trends as investors and corporations withheld investment flows or repatriated them from affected countries.

A Yuan devaluation on its own would probably not be a killer blow as far as the economic cycle in advanced economies was concerned. But it would be trouble. Since a devaluation would represent a Chinese export of deflation, it would frustrate the hopes in Washington, London, Berlin and so on that inflation might slowly start to stir, and hurt corporate earnings and stock prices. It would most likely stop the Federal Reserve dead in its tracks as far as raising interest rate was concerned, or possibly prompt a reversal. The limited chances of a rise in UK interest rates would vanish into thin air.

The real threat of a Yuan devaluation is more about what it would signify. The Chinese authorities could be forced into such a policy, for example, because of a looming or actual banking crisis, and or because economic growth had collapsed to, say, 2 per cent or into a recession. Under these circumstances, economic growth around the would probably stall or fall, spurring new urgent discussions about what on earth central banks might do—so-called helicopter money policies have already been aired—and whether governments might have to abandon current budget strategies. Change was clearly not uppermost in the UK Chancellor’s mind in his recent Cardiff speech, but if China blew a gasket, it would surge to the top of his agenda.

The country that is most vulnerable to a large Yuan depreciation, measured by the amount of trade done with China, is South Korea (17 per cent), closely followed by Taiwan. Other Asian countries that are exposed to a Chinese depreciation include Thailand, Malaysia and the Philippines. Other non-oil producing emerging countries, outside China’s regional supply chains in Asia but which have shifted their trade increasingly to China include Brazil and South Africa.

At the moment, a lot of the world’s currencies are flailing in the face of the strengthening US dollar, and the Yuan has risen against most of them. According to data from the Bank for International Settlements, the trade-weighted value of the Yuan had risen the most between 2010-2015. But a large Yuan depreciation would almost certainly see many countries attempt to shrug off the appreciation to which their own currencies would then be subject. They would want to attempt to preserve trade competitiveness, by engaging in further depreciation themselves, perhaps setting off another phase of so-called currency wars.

A Yuan devaluation would almost certainly be reflected in further across-the-board US dollar appreciation bringing new financial stress to both commodity producers, and to non-financial companies that have borrowed in US dollars. Both topics have figured prominently on the IMF’s financial instability watch-list for some time.

At the moment, it is most likely that the Chinese authorities, conscious of all these risks, and eager to convey a positive impression in its financial diplomacy will try to keep the Yuan relatively stable. The internationalisation of the Yuan, membership of the Special Drawing Right, and the success of the Asian Infrastructure Investment Bank, for example, hinge on a stable and credible currency. The even more important economic rebalancing agenda at home also requires the Yuan to remain relatively firm, provided the authorities are willing and able to address debt and overcapacity problems and use fiscal and social security policies appropriately, and by way of compensation.

But it is hard to be sure the status quo will endure. In the end, China’s politics will be decisive. If, as seems likely, slow growth and political reticence are putting important economic reforms out to grass, and the government continues to rely on credit creation to bolster a high GDP growth target, China will head down a more dangerous path. It will run the gauntlet of capital flight, a greater risk of a banking crisis and then the possibility of a more globally threatening slump in the Yuan. It won’t be in the next three months, but it’s not three years away either.