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The writer is research associate at Oxford university’s China Centre and at Soas. He is also a former chief economist at UBS
Recent speculation about a significant devaluation of the still closely managed renminbi looks rather fanciful given that China runs a large manufacturing trade surplus and a balance of payments surplus of about 2 per cent of GDP. And that is probably understated.
Yet Japan’s surplus is larger, and this has not stopped the yen suffering a deep slump. China could follow suit. The strong dollar is partly the reason but in China, the main story is the persistent decline in interest rates towards zero, domestic economic and financial circumstances, and a policy conundrum.
It should be noted that there is little point in or benefit from a policy-induced or accidental depreciation of the renminbi, which — were it to happen — would have far-reaching economic and political consequences.
From a domestic angle, there is no case for helping exports, given China’s strong external trade position. It would also be precisely wrong to further discourage imports and consumption when significant changes are needed in distributional and income policies to strengthen domestic consumer demand. The government should announce targeted income and consumption fiscal support for households, financed by withdrawing support from companies and state entities, thereby neutralising incentives for capital to leave the country, at least temporarily. But this would involve an unlikely political volte face.
If such fiscal support is limited and monetary easing prevails, a weaker renminbi will aggravate China’s deeply embedded financial imbalances and its endemic proclivity to overproduction and exports.
This would, in turn, exacerbate existing trade frictions in new sectors such as electric vehicles and climate change equipment, and older sectors such as steel, metals and shipbuilding. A perceived policy of currency depreciation would doubtless incur hostile reactions from the US — particularly under another Donald Trump administration — and the EU.
China’s government would also not welcome the disruptive repercussions of a currency depreciation shock. Memories of the 2015 financial chaos in which a mishandled adjustment of the renminbi precipitated significant currency pressure and capital flight are still fresh. And yet, it could still happen.
China’s leaders plan to ease monetary policy, lowering bank reserve requirements and interest rates — as they made clear following the Politburo meeting at the end of last month. Since the latest easing cycle started in 2022, interest rates have fallen by about 0.7 to 0.8 percentage points, with five-year borrowing rates falling to 3.95 per cent. Inflation, however, has fallen by more. Real borrowing rates for companies and households after adjusting for inflation have jumped from a bit above zero to 3 to 5 per cent, tightening the restraints on private firms and the economy.
Unless inflation in China is going to turn up sustainably, which seems a long shot given enduring supply and demand imbalances, nominal interest rates are headed, incrementally, towards zero.
These circumstances then raise for China a new so-called Mundell-Fleming trilemma, named after the two economists who argued that a country can only ever choose two out of these options: an exchange rate pegged to another country, an independent monetary policy and open capital flows. China has typically opted for a soft peg and monetary independence. Over the past several months, the government has moved to harden the peg, and required state banks to intervene to support the renminbi close to about 7.25 to 7.3 to the dollar.
In coming weeks and months, we should expect reductions in interest rates in an economy that remains on the cusp of deflation with softening domestic consumer demand. Loose financial conditions, further falls in some asset prices such as property, and weak investment returns would probably exacerbate unrecorded capital outflows despite controls. In the face of both, the renminbi is likely to get weaker.
This outcome is made all the more likely if the growth of liquidity in the financial system expands so much as to swamp the practical capacity of currency reserves to maintain a relatively fixed currency and finance larger capital outflows. Between 2014 and 2017, I estimate China’s financial system assets rose from four to 11 times the reserves. In 2023, at $65tn, they were 20 times as large. This cannot go on without limit, and eventually, following Stein’s law, the renminbi will be the weakest link.
