Abstract: Recently, the U.S. dollar is becoming unusually strong. With most of the currencies weakening against the dollar, CNY/USD has also changed significantly. From historical experience, given China’s economic fundamentals, the RMB will not depreciate dramatically. In fact, a moderate depreciation helps stabilize China’s macroeconomy. The yuan’s weakening is driven by short- and medium-term instead of long-term factors, and cyclical instead of structural factors. Therefore, stabilizing China’s economy can help anchor the RMB exchange rate.
I. RMB WILL NOT DEPRECIATE DRAMATICALLY
While China is still a developing country, its forex market is not the same as those of average developing countries. And China will not experience a currency slump of 30-50% or more as seen in some countries.
Historically, most of the currency slumps occurred in countries with high inflation or trade deficits. We counted 157 cases of large currency depreciations in the IMF database since the collapse of the Bretton Woods system (defined here as a cumulative annual depreciation of 15%) and found that 148 of them happened against the backdrop of high inflation or trade deficits.
Only nine major depreciations occurred in the context of low inflation and trade surpluses, and they can be divided into five categories: (1) export-oriented economies suffering from severe external crises: South Korea (2008-2009) and Malta (1993); (2) active devaluation through significantly easing monetary conditions: Sweden (2009) and Japan (2013); (3) monetary system reforms: Denmark (2000) and Switzerland (1997); (4) overvaluation of a currency in the early stage: Japan (1996) and the Netherlands (1997); (5) excessive credit expansion and borrowing of foreign debt: Indonesia (2001). As for China, it does not have serious inflation, trade deficit, or any other background that leads to a major currency slide as mentioned above.
In addition to historical experience, in terms of the supply and demand in China’s forex market, the RMB exchange rate is supported by four forces. First, China still maintains an annual goods trade surplus of $500-600 billion; second, China's inflation is rather low compared with that in other countries, which ensures the real purchasing power of the RMB; third, China still maintains a certain degree of capital controls; fourth, after years of reform, the RMB has operated on a more flexible exchange rate mechanism, which can cushion the pressure on RMB supply and demand. Without depreciation pressure accumulated in the past, cross-border capital flows have become relatively more stable, which is significantly different from the situation during 2015-2016 when the RMB was also facing downward pressure.
II. CURRENT WEAKENING OF RMB IS MAINLY DRIVEN BY SHORT-TERM AND CYCLICAL FACTORS
The recent depreciation of the RMB is mainly driven by two forces.
First, the sharp increase of the U.S. dollar index caused by the Fed’s rate hikes. With the U.S. dollar index surging, other major currencies like the euro, yen, and pound have plunged against the dollar, and the RMB also weakened relative to the dollar. But if we look at the trade-weighted RMB exchange rate rather than the CNY-USD exchange rate, the RMB is appreciating against other non-dollar currencies.
Second, China’s sluggish economic performance with export slowing down. The RMB exchange rate and short-term capital flows are closely related to the performance of domestic economy, and past experience shows that the correlation is even higher than that with the US dollar index and the interest rate spread between China and the U.S. The main reason is that China’s forex market is dominated by foreign-invested enterprises instead of financial investors and households. For enterprises, whether settling or selling foreign exchange, borrowing or repaying debt, buying or selling foreign assets are all linked to their orders in hand, their expectations of future cash flow, and domestic economic performance. When the economy is booming, it also comes with net capital inflows and RMB’s appreciation. The recent decline of China’s economic growth and export orders amid the slowdown of global economy thus weighs on the RMB exchange rate.
However, the rising dollar index and the sluggish economic performance are both short-term and cyclical factors instead of long-term and structural ones. The RMB is expected to experience a period of weakness, but as it is mainly driven by short-term and cyclical factors, it will not depreciate all the way down.
III. A MODERATE DEPRECIATION CAN BOOST DOMESTIC ECONOMY; THE KEY TO PREVENTING A RMB SLUMP SHOULD BE BOOSTING DOMESTIC DEMAND RATHER THAN INTERVENING IN THE FOREX MARKET
The monetary authority has always been emphasizing the role of foreign exchange as an automatic stabilizer. Under the current economic environment, a moderate depreciation of the RMB can serve the exact function of boosting demand and stabilizing the macroeconomy as it is helpful to maintain competitiveness of exports and increase the price attractiveness of import substitute products.
A moderate depreciation is not worrisome. Instead, it might help the current economy. What needs to be avoided is a large RMB slump. To that end, the essential policy support is not intervention in the forex market. Past experience demonstrates that the more the authorities intervene in the market, the more pressure on RMB supply and demand will build up, and the stronger the expectations of one-way depreciation, which will instead put the RMB under more pressure; excessive intervention in the forex market will also threaten the supply of base money and macroeconomic stability. Rather, the basic support for the RMB exchange rate comes from China’s economic fundamentals. In the short term, the country should improve economic performance through counter-cyclical fiscal and monetary policies; in the mid-to-long term, structural reform should be implemented to optimize the economic structure.
This article was published on CF40’s WeChat blog on September 29, 2022. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations. It is translated by CF40 and has not been subject to the review of the author himself.
