February 08, 2016
Worries over another Chinese currency devaluation are hanging over financial markets “like the Sword of Damocles,” while Japan is also fighting to keep its currency low to save Abenomics. Can Asia ride out the storm?
As Chinese financial markets paused for the Lunar New Year, market watchers were speculating on just how far the Chinese renminbi may fall in 2016, and its implications for the global economy.
According to Kenneth Rogoff, former chief economist at the International Monetary Fund (IMF), uncertainty over Beijing’s intentions has left markets floundering.
“Since 2016 began, the prospect of a major devaluation of China’s renminbi has been hanging over global markets like the Sword of Damocles. No other source of policy uncertainty has been as destabilizing,” he wrotein Project Syndicate.
“Few observers doubt that China will have to let the renminbi exchange rate float freely sometime over the next decade. The question is how much drama will take place in the interim, as political and economic imperatives collide.”
Despite China’s $600 billion trade surplus for 2015, a combination of factors including slowing economic growth and rising capital outflows have forced China’s central bank into a battle to defend its currency. China’s foreign currency reserves hit a four-year low in January, dropping by nearly $200 billion in two months and an estimated half a trillion dollars in 2015.
“Domestic private investors and global currency traders see a one-way bet against the currency. This has resulted in large-scale private capital outflows since early 2015 as expectations mount that the [People’s Bank of China] will eventually be forced to capitulate once its reserves are sufficiently depleted,” IHS Global Insight’s Rajiv Biswas told Bloomberg News.
On February 5, the renminbi closed at 6.57 to the U.S. dollar in Shanghai trading, down 1.2 percent for the year. A Bloomberg survey found market watchers expect the currency to reach 6.76 by year-end, with Radobank predicting it could fall as low as 7.53.
According to Rogoff, measures allowing private citizens to take up to $50,000 per year out of China along with rising corporate outflows could rapidly deplete official reserves of $3 trillion, leading to further falls in Chinese stocks.
“There is a lot of market speculation that the Chinese will undertake a sizable one-time devaluation, say 10 percent, to weaken the renminbi enough to ease downward pressure on the exchange rate. But, aside from providing fodder for the likes of Donald Trump, who believes that China is an unfair trader, this would be a very dangerous choice of strategy for a government that financial markets do not really trust,” Rogoff said.
“The main risk is that a big devaluation would be interpreted as indicating that China’s economic slowdown is far more severe than people think, in which case money would continue to flee.”
Rogoff suggests Beijing placate nervous investors by establishing “a commission of economists to produce a more realistic and believable set of historical GNP figures,” along with moving toward greater exchange-rate flexibility. The authorities’ move to peg the currency to a basket of 13 currencies, instead of just the dollar, may not be a solution since “a basket peg shares most of the problems of a simple dollar peg…if the dollar retreats in 2016, however, the basket peg implies a stronger renminbi-dollar rate.”
According to the Nikkei’s Hiroshi Murayama, the renminbi needs to depreciate by around 20 to 30 percent against major currencies such as the dollar for China to regain the export competitiveness it enjoyed in 2010.
Yet with China’s gross domestic product (GDP) seen expanding by around 6 percent this year, “a decline of more than 6 percent in the yuan’s value would likely be seen as unacceptable, with China eager to forestall its economic contraction in terms of dollar-based GDP.”
Australia’s central bank has suggested the battle to prevent further capital outflows could be a drag on China’s growth prospects, pointing to a “large stock of unsold housing and substantial excess capacity in the manufacturing and mining industries,” along with the potential for financial distress due to increased debt levels.
“Although monetary policy has scope to ease further, the authorities’ efforts to maintain currency stability in the face of capital outflows and intensified depreciation pressures could limit their appetite to undertake a more sizable easing in monetary policy,” the Reserve Bank of Australia (RBA) said in its latest quarterly monetary policy statement.
“Moreover, the response of investment growth to the easing in financial conditions to date has been relatively muted, and there is uncertainty about how effective current measures will be in supporting activity in the next few quarters. While consumption growth has been resilient so far, there is a risk that continued weakness in a sizable part of the economy will eventually weigh on growth in household incomes and consumption.”
Yen Fights Back
Meanwhile, the Bank of Japan’s recent decision to join a number of European countries in adopting negative interest rates has failed to stave off a “flight to quality” back to the yen. Despite an immediate drop in the currency and a rise in Tokyo stocks following the BOJ’s surprise January 29 announcement, a subsequent rebound saw the yen post its biggest weekly rally last week since 2009.
Nikko Asset Management’s John Vail argued that the Japanese central bank’s decision sought “not to start a currency war, but to incentivize domestic business investment and risk taking in Japan, not only by banks, but also by companies and individuals.”
According to Vail, the move “opens the possibility of decreasing the rate further, which is a new, powerful weapon, like in the [European Central Bank’s] current arsenal, to counter a further worsening economy.” A weaker yen may help the BOJ’s inflation goal, “but a much weaker yen is not likely desired by the BOJ, especially when voters are tired of too much food inflation and when the Japanese government is hoping that the US Congress will pass [Trans-Pacific Partnership] legislation.”
Jesper Koll, chief executive of WisdomTree Japan, said adapting negative rates was “exactly what was needed to re-assert the relentless, pro-active and pro-growth determination that underlies Abenomics. The fact that [BOJ Governor Haruhiko] Kuroda goes out on a limb – five to four vote – re-asserts that this is his BOJ, not the technocratic non-risk taking BOJ of the past.”
In the meantime though, the rallies in the Japanese yen and euro “reflect sharp drops in the dollar as the odds of further Fed hikes have faded. Based on federal funds futures, odds are less than even for another quarter-point increase until well into 2017,” said Barron’s Asia writer Randall W. Forsyth.
Asia’s emerging markets are likely to be the biggest victims of any further slide in the Chinese economy and its currency, along with a rising dollar on the back of higher U.S. interest rates. The MSCI Emerging Markets Index, a measure of emerging market stocks, dived by nearly 15 percent in 2015, and a repeat performance could be possible in 2016 should China’s slowdown worsen.
“The current crisis will persist and may become a full-blown bear market if the Fed decides to implement consecutive hikes as it indicated in December 2015,” said Nikko Asset Management’s Yu-Ming Wang.
“In our view, the Fed will blink, just as President Mario Draghi has hinted the European Central Bank will do and as the Bank of Japan did at the end of January by cutting interest rates to negative. This should be positive for global equity markets and may help us avoid the grim year that January has suggested.”
After a rough start to 2016, Asian investors can only hope that policymakers in Beijing, Tokyo and Washington start working to ensure the Year of the Monkey brings better fortune before the mythical sword strikes.
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