Fur­ther yuan slide, if any, will be mod­est

In all, tak­ing into ac­count that China’s real econ­omy does not re­ally need a weaker ex­change rate any more, con­sid­er­ing the spec­trum of choices, the PBoC’s over­all cost-ben­e­fit anal­y­sis is un­likely to point to a ma­jor de­pre­ci­a­tion of the yuan.

China Daily (USA) - - VIEWS -

The re­cent de­pre­ci­a­tion of the yuan against the US dol­lar has cre­ated anx­i­ety in China. But it largely re­flects a strongUS dol­lar driven by in­vestor ex­pec­ta­tions about high­erUS in­ter­est rates.

The pres­sure has in­creased after Don­ald Trump’s elec­tion as the nex­tUS pres­i­dent. Mar­kets are bet­ting on wider fis­cal deficits, stronger growth and higher in­fla­tion in theUS— the lat­ter in part be­cause of more pro­tec­tion­ism.

How­ever, the yuan has ac­tu­ally de­pre­ci­ated less against theUS dol­lar than other ma­jor cur­ren­cies. As a re­sult, China’s tradeweighted, ef­fec­tive ex­change rate has re­mained broadly con­stant in re­cent months.

Since late 2014, when net fi­nan­cial out­flows be­came large enough to put de­pre­ci­a­tion pres­sure on the for­eign ex­change mar­ket, the Peo­ple’s Bank of China, the coun­try’s cen­tral bank, has walked a fine line be­tween al­low­ing some de­pre­ci­a­tion in the face of pres­sure while re­sist­ing sig­nif­i­cant weak­en­ing of the yuan.

How­ever, a pol­icy of curb­ing de­pre­ci­a­tion pres­sures can be costly in terms of for­eign ex­change re­serves and po­ten­tially un­sus­tain­able. Since early last year China’s re­serves have de­clined by $677 bil­lion, ad­justed for val­u­a­tion ef­fects, or 17 per­cent of the to­tal.

Go­ing for­ward, un­cer­tainty in global mar­kets is high, as it is un­clear how macroe­co­nomic poli­cies will change un­der the in­com­ing Trump ad­min­is­tra­tion. But de­pre­ci­a­tion pres­sures on the yuan are likely to re­main, re­flect­ing the prospect of high­erUS in­ter­est rates and a strongUS dol­lar, as well as con­tin­ued port­fo­lio re­bal­anc­ing.

In the face of con­tin­ued out­flows, there may be a case for re­duc­ing or even aban­don­ing for­eign ex­change in­ter­ven­tion and let­ting the for­eign ex­change mar­ket pres­sures drive the yuan weaker. This would limit or even halt the re­duc­tion of for­eign ex­change re­serves and could re­set ex­pec­ta­tions for the yuan go­ing for­ward.

How­ever, while cap­i­tal ac­count fac­tors point to fur­ther de­pre­ci­a­tion, in terms of the real econ­omy there is no ob­vi­ous case for sig­nif­i­cant fur­ther trade-weighted de­pre­ci­a­tion. In­deed, China still runs a healthy cur­rent ac­count sur­plus and the global mar­ket share of its ex­ports is still ris­ing.

In such cir­cum­stances, a sig­nif­i­cant de­pre­ci­a­tion may lead to over­shoot­ing, which would be un­help­ful for the real econ­omy. This is an is­sue for China’s pol­i­cy­mak­ers, as they tend to em­ploy a “real econ­omy” per­spec­tive on the ex­change rate pol­icy.

A rapid, large de­pre­ci­a­tion could also com­pro­mise con­fi­dence in the yuan, spark tur­moil in global for­eign ex­change mar­kets and evoke un­favourable re­ac­tions from politi­cians around the world. Such con­sid­er­a­tions make steps to re­duce cap­i­tal out­flows more likely than sig­nif­i­cant de­pre­ci­a­tion.

While there is still much un­cer­tainty about Trump’s China pol­icy, there are some con­clu­sions that we can al­ready draw. On balance, we ex­pect the Trump ad­min­is­tra­tion pol­icy to be a neg­a­tive for China’s ex­ports. Un­der Trump theUS may also push for a stronger yuan.

Equally im­por­tant, the Trump ad­min­is­tra­tion is likely to put much more em­pha­sis than that of in­cum­bent Pres­i­dent Barack Obama on shrink­ing theUS trade deficits— both the over­all one and the one with China. And the ap­pre­ci­a­tion of theUS dol­lar will make it harder to bring th­ese ex­ter­nal deficits down. This will add to pres­sure for a stronger yuan since China would pre­fer a stronger yuan rather than re­stric­tions on its ex­ports.

In all, tak­ing into ac­count that China’s real econ­omy does not re­ally need a weaker ex­change rate any more, con­sid­er­ing the spec­trum of choices, the PBoC’s over­all cost-ben­e­fit anal­y­sis is un­likely to point to a ma­jor de­pre­ci­a­tion of the yuan.

Thus, in an en­vi­ron­ment of higher US bond yields and ac­com­pa­ny­ing up­ward pres­sure on the US dol­lar, we ex­pect the PBoC to con­tinue to walk a fine line be­tween al­low­ing some de­pre­ci­a­tion while re­sist­ing sig­nif­i­cant yuan weak­en­ing. We fore­cast the yuan-US dol­lar rate to be 6.95 at the end of 2016 and ex­pect it to hover around that level in 2017.

To con­tain for­eign ex­change mar­ket pres­sures, we ex­pect ef­forts to more strictly en­force ex­ist­ing cap­i­tal ac­count re­stric­tions and prob­a­bly im­ple­ment ad­di­tional ones, fol­low­ing the re­cent ban on us­ingUnion Pay to trans­fer money toHong Kong to buy in­sur­ance prod­ucts. The gov­ern­ment could also take low­er­pro­file steps such as slow­ing down out­bound in­vest­ment by State-owned en­ter­prises and banks’ overseas lend­ing. The au­thor is head of Asia Eco­nomics at Ox­ford Eco­nomics.

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