Why China will avoid a big, destabilising yuan devaluation

The renminbi surprised world markets with its unexpected devaluations first in August 2015 and then in January. The devaluations affected confidence both domestically and overseas, and even contributed to the delay by the US Federal Reserve Board in raising the US interest rate. They also led to many rumours about a potential significant devaluation of up to 20 per cent. Many hedge funds are known to have taken large short positions against the renminbi, with some betting that the exchange rate will fall to as low as eight yuan per US dollar.

As Chinese economic growth slows, from close to 10 per cent to around 6.5 per cent, in transitioning to a “new normal”, the Western media have been almost uniformly negative about its prospects. Will the renminbi be devalued again? As both Premier Li Keqiang (李克強) and Bank of China governor Zhou Xiaochuan (周小川) have assured the public recently, and for the reasons laid out below, the renminbi is unlikely to devalue abruptly and significantly, although there may be small fluctuations.

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A reliable indicator of whether a currency is overvalued is whether the balance of trade in goods and services is consistently negative. If a country consistently runs a large trade deficit, then its currency is likely to be overvalued. In 2015, China still had a sizeable trade surplus, in the order of 4.2 per cent of its GDP, or approximately US$450 billion a year, and is expected to continue to run a significant trade surplus in the foreseeable future. If any currency is overvalued today, it is probably the US dollar, not the renminbi.

It is well known that stable exchange rates facilitate cross-border trade and cross-border long-term direct and portfolio investment. Volatile exchange rates have the opposite effect. The Chinese economy needs relatively stable exchange rates to continue to grow and prosper. A devaluation of the renminbi at this time is likely to affect confidence both at home and abroad, and attract more currency speculation, leading to greater exchange rate volatility.

Would a devaluation increase Chinese exports? A small devaluation per se is unlikely to do so significantly even though it may increase the profits of Chinese exporters in renminbi terms, especially given that most world economies are either in recession, stagnation or a slow recovery. Moreover, in order for a devaluation to increase Chinese exports meaningfully, it may have to be in the order of 15 per cent or higher. But it is not really in the best interests of China to return to making garments, shoes and stuffed toys all over again, with the low standard of living that implies for its workers. Furthermore, the Chinese economy has also grown too large to be sustainable by increases in exports alone.

In addition, a devaluation is helpful only to the extent that potential competitors do not also devalue in response. If they do, then not only is no advantage gained, but the terms of trade will also deteriorate significantly. Instead, China would be much better off trying to move up the value chain in its exports, as Japan, Hong Kong, Taiwan and South Korea did before.

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Moreover, for the Chinese people, it is even more important for the renminbi to retain its purchasing power, both domestically and abroad. A devaluation would have a direct impact on their confidence in the renminbi and the economy. It is also in China’s interests to promote the use of the renminbi as a medium of international exchange and eventually as an international store of value. All this requires a relatively stable exchange rate vis-à-vis the US dollar.