The Chinese renminbi (RMB), otherwise known as the yuan, has fallen to its lowest level in a decade against the US dollar this past week. The currency has been on a downwards spiral in recent quarters and is plummeting towards levels not seen since the global financial crisis. As it threatens to move above RMB 7 against the dollar – a ‘psychological’ threshold due to the connotations of the character ‘seven’ with prosperity in Mandarin , concerns are being raised by China’s trade-war enemies America that they may be letting their currency crash on purpose. During his ultimately successful 2016 presidential campaign, Trump repeatedly labelled China a ‘currency manipulator’, backing up these claims as recently as a few months ago in an interview with CNBC . China has certainly devalued its currency to cheapen exports in the past, but is there any evidence to support these claims now?
Unlike the UK and US, the Chinese government has historically yielded strict control over the fluctuations of the renminbi on the forex market. The People’s Bank of China (PBOC), the central bank that for all intents and purposes is controlled by the government, has historically regulated currency trading – fixing the exchange rate from 1995 to 2005 at around 8 yuan to the dollar . This currency ‘peg’ was carried out through a combination of monetary policy and currency manipulation – more on this later. Currently, the PBOC operates a trading band where the exchange rate is allowed to fluctuate around the daily midpoint that is set by the bank. Since the introduction of the band in 2005, the government has slowly loosened control, tending towards a more free market approach. As such, the trading band operated has been gradually widened, allowing the yuan to fluctuate more. This is largely due to the difficulty in maintaining an iron grip on currency levels whilst trying to maintain economic growth which requires an increased free movement of capital. The PBOC currently sets the midpoint dependent on the previous days’ closing value and allows the currency to fluctuate to within 2% of the midpoint . As such, the yuan is as close to floating freely against the dollar as it has ever been before. However, the US fear that the PBOC could deliberately undervalue the yuan by setting lower and lower midpoints. Why would they do this? Before addressing the key question, let us first look at currency manipulation in more detail.
Under the Trade Facilitation and Trade Enforcement Act of 2015, the US Treasury identifies currency manipulating countries as having met all three of the following criteria :
- A ‘significant’ bilateral trade surplus with the United States that exceeds $20 billion over the last 4 quarters.
- A ‘material’ global current account surplus of 3% or more of GDP.
- Repeated net purchases of foreign currency totalling 2% or more of GDP – ‘persistent one-sided intervention’.
In a nutshell, currency manipulation is when the government or central bank of a country that is already running a trade surplus with the US buys the dollar to such an extent that it has the effect of decreasing the value of their domestic currency against the dollar respectively. This bypasses natural supply and demand – when a country buys US dollar it increases the demand for the dollar, appreciating its value whilst depreciating the value of the domestic currency and vice versa. A country artificially depreciating its currency against the dollar by buying the US currency in exchange has the effect of making the countries’ exports cheaper for the US, potentially widening the trade deficit for the US. The very thing Trump is trying to cut down on.
If a major trading partner were to meet the three criteria, they would publicly be declared a ‘currency manipulator’, and the following procedure would be followed. A year of negotiation is given for the country in question to adapt monetary policy appropriately before the President is allowed to take aggressive action such as removing any investment and prohibiting the procurement of any goods and services from said country. It is interesting to note that the US Treasury stopped short of labelling China as a currency manipulating country this month, although the lack of official recognition is far from being synonymous to innocence.
The recent fall of the renminbi has been coupled with the rise of the dollar to seven-week highs, largely due to the Federal Reserve’s decision to hike up interest rates. In the midst of the Sino-US trade war, America is concerned that China is deliberately letting its currency fall as a move to hit back against US tariffs. Such a strategy would work in theory as they would effectively cancel out the added expense of Chinese exports due to trade tariffs impose. However, it is highly improbable that China is deliberately devaluing the renminbi. Such a manoeuvre would mean Chinese consumers and businesses suffering a double blow of price increases due to tit-for-tat tariffs as well as the weakened purchasing power due to the devaluation of their currency. It would also affect Chinese companies that have borrowed debt in US dollars, a common practice in recent times.
Let us examine the numbers to gain a clearer picture at Chinese monetary policy. Although China still runs a healthy trade surplus to the US – far greater than the $20 billion upper limit given in the criteria above, its current account surplus has been swiftly declining, and became a deficit in the first quarter of 2018 . Since opening its economy in the 1980’s, China has managed to stockpile the largest foreign currency reserves in the world, currently valued at around 3 trillion US dollars – to put this into context the next largest foreign exchange reserve is held by Japan with a measly 1.3 trillion US dollars in comparison . However, this statistic needs to be examined in context.
Source: Trading Economics
As can be seen in the graph, China’s foreign exchange reserves has been decreasing since it peaked at around 4 trillion dollars in 2014. This is because in recent times China has actually been selling its foreign currency reserves in an attempt to drive up the value of the renminbi. Ironically, this practice is technically a form of currency manipulation, but not a cause of complaint from their trans-Pacific trading partners. So, there we have it – there is currently insufficient evidence to suggest China are letting the yuan drop – in fact, they have been attempting to counteract this if anything!
Down, down, down
The decline of the MSCI Emerging Markets Currency Index with the US dollar mirrored the decline of the renminbi in the first 3 fiscal quarters of 2018 , further supporting the Chinese argument that they are not devaluing the currency. So, what are the causes of the currency crash if not governmental intervention? The main reason is most likely the fact that Chinese economic growth has slowly but surely been grinding towards a halt – real GDP growth in the first quarter of 2018 was 6.8% compared to over 10% in 2010 . The rapid economic growth was largely riding the wave of China’s ascension from the dabbler to by far the largest exporter in the world. According to data collected by the IMF, Chinese exports were growing by an average of 17% a year for three decades. By becoming the largest exporter in the world, the pace of her export growth became unsustainable, and this coupled with the conclusion of the efficiency boosting transition from a control to market economy has contributed towards the fall in economic growth. The Chinese equity market has also been on a downwards slope, least of all due to uncertainty arising from the trade war, with the CSI 300 Index -the top 300 companies traded on the Shanghai and Shenzhen stock exchanges – down 21% since the start of the year . Capital is leaving the country at an unprecedented pace due to lack of investor confidence and governmental policy. This has led to the fall in the renminbi against the dollar, which has been exacerbated by the surprisingly strong performance of the dollar.
The yuan has almost certainly been falling naturally rather than due to governmental currency manipulation. Key factors driving the fall are the slowdown in Chinese economic growth and strong performance of the dollar. In the midst of the Chinese-American trade war, these are uncertain times and it is anyone’s guess to how the Chinese government would react if tensions continue to escalate. The use of currency as a potential weapon would certainly be effective, although it would be a bitter pill for its citizens to swallow. The RMB 7 level will be a key marker in the future, as a sharp fall past it would damage domestic confidence, leading to further capital outflows, holes China are trying desperately to plug. The PBOC would go to any means to limit market volatility, but it is entirely possible that RMB 7 will become the new benchmark for the future.