The potential depreciation of the Chinese yuan has been worrying investors this year due to its negative impact on global financial stability and role in exporting deflation globally.
But alarming media headlines predicting the rapid, disorderly depreciation of the yuan have since been replaced by news about Brexit, the US presidential elections and other geopolitical developments. Economic data continues to point to the potential for further yuan depreciation, but we believe this would be orderly – and less of a threat to the global financial landscape than the headlines would have us believe.
As we see it, Beijing has one overriding objective: the downward bias of the yuan on a trade-weighted basis. The yuan’s rich valuation, relative to its own history, and the prospects of more capital account liberalisation in coming years, will make China’s defence of its currency more difficult and costly. This is why allowing the currency to adjust towards a more reasonable valuation looks like a sensible strategy.
In 2005, China ended its de facto currency peg to the dollar. Since then, the yuan’s real effective exchange rate (REER) has risen by 40 per cent, largely via the yuan’s appreciation against the dollar. The yuan’s strength has dampened China’s export performance in recent years, especially when combined with weak global demand. However, it has had some positive effects too: it has allowed Chinese consumers and investors to benefit from cheaper imports of goods and services, and to take advantage of international investment opportunities.
The yuan is expensive relative to its own 10-year history, but whether it is fairly valued remains hotly debated. The International Monetary Fund believes it is. Following a review of the economy in June, it stated: “The renminbi (CNY) is assessed as broadly in line with fundamentals, similar to our assessment in last year’s Article 4 consultation”. This is a further indication that a high-speed, disorderly yuan depreciation is unlikely. The accumulation of China’s foreign exchange reserve has also started to reverse over the past two and a half years, which adds to the argument that the currency is close to fair value based on external positions.
Early 2014 marked the end of the one-way appreciation of the yuan against the dollar, reflecting the economic pain created by a stronger dollar and domestic slowdown. China has since had five significant episodes of yuan depreciation, including the one-off 3 per cent devaluation on 11 August 2015, unnerving markets and helping fuel fears that similar episodes might follow.
Since we can assume that Beijing’s objective is to continue with this trend, the outlook for the broad dollar is an important determinant of medium-term US dollar/yuan exchange rates. If the multi-year dollar bull market is approaching its end, then the yuan could leverage the dollar weakness to achieve a depreciation against its trading partners. For example, when the US dollar REER weakened between January and April 2016, the yuan actually appreciated against the dollar by 2 per cent. So China achieved its aim of weakening its currency against a basket of currencies by riding the weaker dollar, but without weakening against the dollar.
Chinese authorities have enough policy tools at their disposal to avoid a currency collapse. But valuation and economic adjustments imply that the yuan is likely to depreciate further, on a trade-weighted basis, over the medium term. This should also lead to episodes of weakening against the dollar.
For international investors with appropriate currency hedging solutions, both the Chinese equities and fixed income markets offer the means to tap into China’s new economy, as well as income opportunities. This is particularly important, as China’s capital markets are expected to become better represented in various important benchmark indices in coming years, opening them up to many more global investors.
