Monday 20/05/2019

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Sharp CNY depreciation just around the corner?

Chief Economist

Several reputed investors have declared war on the RMB in recent days. How worried should we about an imminent collapse of the RMB? Should we believe Chinese policymakers stating that there is ‘no basis’ for big RMB depreciation? This question brings us to the heart of the problems facing China. In short, although it’s impossible to exclude the scenario of a large one-off devaluation, we don’t think this will happen anytime soon.

China looks set to avoid a hard landing in 2016 as the stimulus measures taken earlier should stabilize economic activity in the months to come. At the same time, however, longer term consensus estimates for Chinese growth still look too optimistic and the challenges linked to the transition from a planned economy towards a more market-based consumption driven economy loom large. The combination of continued fast progress on structural reforms (like capital account liberalization) and high growth (in line with the new official growth target of around 6.5%) does not look feasible. At first glance, a major currency depreciation could indeed come to the rescue and reconcile both goals.

That said, as China is now the second largest economic player in the world, with Chinese economic activity accounting for approximately 15% of global GDP, a large depreciation would reinforce the deflationary forces already impacting today’s world. As a rule of thumb, a 10% depreciation of the trade weighted CNY boosts Chinese GDP growth by (only) 0.5 percentage points in the first year after the shock. However, this assumes that there are no negative spillovers to the rest of the world. The latter, however, is highly doubtful. More likely than not, a sharp depreciation would have an important negative on global financial markets, spur monetary retaliation efforts by other central banks, in turn weighing on consumer and business sentiment across the globe. Moreover, it would also negatively affect Chinese consumer spending and be at odds with Chinese policymakers’ strategy to rebalance the economy. What’s more, China’s ambitions to play a more important role on the international political scene would probably attract a lot of skepticism as a result.

Another option is that China reverses earlier measures with regards to capital account opening in an attempt to stop capital outflows and FX reserve depletion so that monetary policy would be more effective. Anecdotal evidence suggests this may already be happening in fact. This does make sense to some extent. But, here again, this strategy would be largely interpreted as China cutting back on earlier promises to proceed with reforms thereby desperately trying to clutch at old recipes. All this basically means that Chinese policymakers are stuck and that they are tied to some sort of stop-and-go policy in the years to come. With credit still growing at unsustainable levels and debt serving costs moving up fast, this “kicking the can down the road” strategy is an increasingly uncomfortable situation to be in.

The upshot is that a hard landing will probably be avoided for now as the stabilizing effect of earlier stimulus measures slowly starts to kick in. On the other hand, the medium to longer term outlook still looks incredibly challenging against the back of the Chinese debt overhang, ageing population, less potential to catch up from behind and difficulties linked to further economic rebalancing. Hard landing fears, therefore, will continue to linger around for many more years. It’s not clear whether financial markets are taking this fully into account. Depreciation pressures are likely to persist.  At the same time, any depreciation will probably be gradual given the amount of FX reserves available. It remains unclear how financial markets will react to this, particularly given the perceived lack of communication by Chinese authorities with regards to how they will manage the RMB (even though it should be clear that RMB will no longer track USD if the latter would tend to appreciate further).

Further capital account liberalization looks set to occur in a very gradual way. The significant efforts done last year are closely linked to China’s ambition to include the RMB in the IMF’s SDR basket but these are likely to be put on halt for now. Given the very low external debt levels, high FX reserves and capital controls it seems impossible that international investors can force China into a typical EM-crisis thereby triggering a large one-off depreciation from a currency peg deemed unsustainable. As stated before, we cannot exclude that China will aim for it at some point. For reasons explained earlier, however, we don’t think this will happen anytime soon. A gradual managed depreciation is likely to stay in place for now.

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