Beijing can’t allow the yuan to keep falling, says Maximilian Kärnfelt. A weaker currency is good for exporters, but bad for other parts of the economy.
Since the US-China trade war started in 2018, Beijing has thumbed its nose at higher US import duties by letting the yuan (CNY) depreciate by more than seven percent. This has kept Chinese exports from plummeting, but burdened other, less sturdy parts of the economy. As a result, China’s leadership does not have much room for further controlled depreciation – at some point, international investors could even sell CNY-denominated assets, although capital controls are in place.
Depreciation has shielded China’s exporters from the trade war, easing the pressure on corporate profits and jobs - two pillars of social stability. But it has shifted the burden onto external finances by making it more expensive to import, invest abroad, and service foreign debt. Government and consumers – and even companies – are feeling the pinch. If the US does not lift tariffs, China will only have limited room to use its currency to shield its export sector.
Supporting exports, hurting external purchasing power
At the start of last year, the CNY traded at 6.5 yuan to the USD and it now trades around 7, a depreciation of 7.4 percent. Investors sold yuan when the US announced new tariffs and escalated the trade war; they bought yuan on news that talks were progressing – and recently did so again on hopes of a “phase one” trade agreement. But there has been more escalation than de-escalation and, as Chinese economic growth slowed, downward pressure on the yuan left its mark.
The People’s Bank of China (PBOC) could have resisted that trend, but appears to have happily desisted. China’s central bank avoided selling foreign currency reserves to prop up or inflate the value of its currency – the country’s reserves increased by more than 27 billion USD last year. Instead, the PBOC was careful to move the CNY-rate of its daily dollar fixing gradually downwards with the market, while carefully controlling resulting capital outflows.
A weaker currency has ensured China’s exports only contracted slightly. In September, China’s year-to-date exports have fallen by only 0.2 percent. By supporting exports, China’s authorities have kept some of the negative effects from the trade war from causing social instability. This was an especially important goal ahead of the 70th anniversary of the founding of the People’s Republic of China (PRC), though it is a policy priority at any time.
But a depreciating yuan has hurt China’s external purchasing power, which means economic foreign policy has become more expensive. Foreign infrastructure projects like those connected to the Belt and Road Initiative (BRI) network have become more costly for their Chinese backers. Depreciation also worked against Beijing’s goal of internationalizing the yuan as foreign investors’ confidence in the value of the currency took a knock or two.
Depreciation has, furthermore, made buying anything in USD more expensive for Chinese companies. They import enormous amounts of USD-denominated commodities such as oil and gas, have shown a large appetite for acquiring foreign businesses in recent years, and have steadily raised their exposure to debt in foreign currencies. In particular, servicing these foreign debts would become increasingly difficult if the yuan were to decline more.
Beijing cannot let the yuan lose much more in value
The yuan’s falling value looks set to hit consumers - imported goods will become more expensive and inflation risks increase. If exporters sell dollar earnings to the PBOC, the domestic money supply could rise as the central bank prints money. It had avoided this problem in the past by instructing banks to keep a large capital reserves, but recently cut requirements in response to slowing economic growth.
Beijing cannot let the yuan lose much more in value – there appears to be little room below the 2008 low of 7.2 to the dollar. Corporate debt defaults have not yet risen, but Chinese billions continue to flow into foreign projects and living costs are rising. Food prices in September were 8.4 percent higher than the year before, and average houses price in 70 cities in August were up 9 percent. Depreciation is not to blame for these trends, but could yet worsen them.
If that won’t deter Beijing, the specter of capital flight surely will. If investors fear more depreciation or view current exchange-rate losses on investments as too high, they could sell their yuan-denominated assets. Capital controls are meant to prevent this, but panicked investors could trigger capital flight, financial-sector turmoil and a drop in the currency. As in 2015, China would have to spend its prized currency reserves to defend the yuan.