Dr Matthew Peter (Chief Economist)
Drew Klease CFA (Principal Economist)
Jimmy Louca CFA (Senior Economist)
The world may have qualified reasons to welcome yuan devaluation if Chinese policymakers’ assertions are taken at face value – that shifting the yuan’s price setting towards market forces is the sole motivation.
With excess capacity within its economy, stimulus from improvements in the trade balance can help lift Chinese domestic demand without placing upward pressure on inflation. Furthermore, stronger Chinese domestic demand would act as a partial offset to the currency devaluation, particularly for countries exporting to China.
The upshot is that China’s trading partners could stabilise growth with relatively modest easings of monetary policy that would not completely erode the currency advantage gained by China. The fact that China’s trading partners would not have to act with aggressive monetary easing to protect economic growth limits the potential for an outbreak of an all-out currency war.
However, if the Chinese economy is in deeper trouble than believed, the recent currency devaluations may be the harbinger of more to come and that would be bad for the world.
Winston Churchill’s famous words about Russia that, “It is a riddle wrapped in a mystery inside an enigma” is equally applicable to China.
Its unique “Socialism with Chinese characteristics” melds state-capitalism with private enterprise and a centralised political system. Decisions and processes, at least to outsiders, seem opaque.
So the 11 August “one-off” yuan devaluation followed by two more in quick-fire succession prompted much head-scratching.
But perhaps an explanation lay in some of the words that follow the first part of Churchill’s observations on Russia: “It is a riddle wrapped in a mystery inside an enigma but perhaps there is a key. That key is Russian national interest.”
China, like every other country, was acting in its national interest by devaluing the yuan and rolling out a new currency setting mechanism that takes as a reference the previous day’s closing rate, demand and supply conditions in the foreign exchange market and the overnight movement of major currencies.
Critics, the US Congress chief among them, may cite the devaluation as further evidence of China’s mercantilism – the economic idea that a government should regulate a nation’s economy in a way that augments state power at the expense of rival economic powers.
However, before others cast stones, it may be useful to reflect that the source of China’s currency moves stem from elsewhere. The big developed economies (stand up the European Union and Japan) have slashed interest rates to or near zero and embarked on unprecedented quantitative easings that have pushed down their exchange rates.
All the while China has weathered an effective currency appreciation of nearly 15 per cent since June 2014 (Figure 1) even as its economy has slowed.
Yuan appreciation is broad-based across China’s major trading partners as the euro, South Korea's won and Japan's yen are down14, 11 and 14 per cent respectively over the past year against China’s currency.
Rather than symbolising mercantilism or economic belligerence, it is more accurate to read yuan devaluation as an overdue correction amid global interest rate and currency policies that have diminished China’s competitiveness.
Motivations for change
Make no mistake, China needs a boost as it is in a cyclical slowdown. The slumping property market has been a drag on the broader economy and a raft of policy measures to stabilise growth haven’t had the desired effect, so far.
Recent data readings are sobering.
Annual industrial production growth dropped to 6 per cent in July, down from the 8.3 per cent average during 2014. Urban fixed asset investment growth has slowed to around 10.3 per cent over the year to July from around 15 per cent a year ago and 20 per cent two years ago.
Export values fell 8.4 per cent over the year to July, hit by lacklustre global demand and of course a strong currency.
No wonder policymakers have come under pressure to allow the currency to fall to help to cushion the economic slowdown. Beijing says there is no need for further yuan adjustment to promote exports but unofficial sources opine that the currency may need to decline another 10 per cent.
A financial liberalisation motivation is also a driver, we believe.
China has been campaigning for a seat at the global economic elite table through inclusion in the IMF’s currency basket, the special drawing rights (SDR). A market-based exchange rate is one criteria and the more market-driven pricing mechanism’s introduction can be seen in that light.
The IMF undertakes a SDR review every five years and is due to meet late this year to pass judgment on China’s currency. SDR inclusion is important for China’s sense of self. It would be another milestone in the country’s “peaceful rise”.
Implications of the devaluation
To date, the USD-CNY has devalued around 5 per cent. As currency devaluations alter the relative competitiveness of countries, typically, it redistributes rather than changes global growth.
Devaluations tend to favour the country making them at the expense of those that do not. How devaluations affect economies and financial markets depends on the underlying motivations.
The world may have qualified reasons to welcome yuan devaluation if Chinese policymakers’ assertions are taken at value – that shifting the yuan’s price setting towards market forces is the sole motivation. If economic deterioration is the motivation, that’s a different story.
Simulations within our proprietary version of the NiGEM global economic model suggest a 5 per cent yuan devaluation would lift real Chinese GDP growth by around ½ a percentage point by 2016, helping shore up the economy during a period of cyclical weakness.
The Chinese economy is currently operating with excess capacity and thus in a position to absorb currency devaluation with little of the inflationary forces that follow devaluing economies operating at full capacity.
Consequently, Chinese domestic demand can expand along with an improvement in the trade balance. Furthermore, stronger Chinese domestic demand would act as a partial offset to the currency devaluation, particularly for countries exporting to China.
The upshot is that China’s trading partners could stabilise growth with relatively modest easings of monetary policy that would not completely erode the currency advantage gained by China. The fact that China’s trading partners would not have to act with aggressive monetary easings to protect economic growth limits the potential for an outbreak of an all-out currency war.
This generally sanguine interpretation of events means it is unlikely that the recent yuan devaluation will lead to a global currency war. Nevertheless, it is a lively topic of market discussion and so we address the issue in But what about the risk of a currency war?
Our simulations show that the central banks of China’s close trading partners – the US, South Korea and Australia – could stabilise their growth rates by easing monetary policy by around ½ of a 25 basis point cut to interest rates between now and the end of 2016.
For Japan and the euro area, where official interest rates are likely to remain zero-bound over 2016, a modest extension of quantitative easing will be sufficient to stabilise economic growth.
But what about the risk of a currency war?
Our central case is that the Chinese economy is in a cyclical slowdown and this coupled with rapid yuan appreciation makes a reasonable case for devaluation. However, if the Chinese economy is in deeper trouble than believed, the recent currency devaluations may be the harbinger of more to come and that would be bad for the world.
If policymakers resorted to deeper devaluations to revive a stalling economy, China would in effect be stealing growth from trading partners by favouring exporters at the expense of domestic demand. In this scenario, Chinese domestic demand would be treading water while trading partners suffer from a drop in competitiveness owing to appreciations of their currencies against the yuan.
A progression to even looser global monetary policies would follow as China’s trading partners attempt to recover competitiveness, opening the door to currency wars.
Our simulations suggest that a weakening of Chinese domestic demand to below 6 per cent could compel policymakers to devalue the USD-CNY by 10 per cent, over the coming year, to stabilise the economy. This is the size of the devaluation anticipated by economists downbeat on China.
China’s neighbours would suffer most. The Japanese economy would shrink by ½ percentage point, while real South Korean GDP would fall by around one per cent after two years, according to our projections.
China’s trading partners would feel compelled to respond.
The South Korean and Taiwanese central banks, for instance, would need to cut rates by more than 50 basis points. There would be an extension of quantitative easing programs in Europe and Japan to fight off deflationary impulses.
Central banks considering rate rates over the coming 12 months, such as the US Federal Reserve and Bank of England, would adopt a much more gradual approach.
Our simulations suggest that shocks would cause official US interest rates to settle in the 1.75-2.00 per cent range by the end of 2017 rather than 2.25-2.50 per cent in our baseline case.
It is not a picture we are anticipating, at this time.
Australia as collateral damage
A prolonged Chinese growth slowdown would be especially bad for Australian iron ore and coal exporters and the broader national economy would suffer collateral damage.
The dwindling manoeuvring room available to Australian policy makers to respond to external shocks exacerbates the situation.
In a pessimistic scenario, iron ore prices would fall back below US$50 per tonne and hard coking and thermal coal prices would become entrenched at lower levels of around US$80 per tonne and US$50 per tonne, respectively.
Persistent prices at these levels would eventually wipe out around another 40 million tonnes of marginal supply across bulk commodities, translating to $5 billion in lost annual revenue by the end of 2016.
The mining profitability drop would lead to further declines in business investment from a forecast fall of 3.7 per cent in 2016 to 6.0 per cent fall as resources companies looked for further capex savings from existing operations and pulled back on their few remaining expansion plans.
Pressure on mining industry as well as wider company profits would add stresses to already strained Federal and State government budgets.
We estimate that the Federal Budget would be hit by a revenue shortfall that would grow to $10 billion a year by 2018.
Our modelling (Figure 2) suggests that the hit to GDP and a sustained rise in the unemployment rate would pressure the RBA to cut rates. At the same time, the RBA would be wary of cutting the official cash rate too aggressively for fear of over-exciting an already warm housing market.
In our simulations, the RBA would lower rates to 1.5 per cent, a level that would be needed through 2017.
Constraints on fiscal and monetary policy emphasise the exposed nature of the Australian economy to external shocks. With the transition from mining to non-mining activity occurring slowly, the inability of policy makers to respond to a sharp deterioration in external conditions could condemn the economy to a lengthy period of sub-trend growth.
A hit to growth from an external shock coming from China would extend the number of sub-trend growth years since the GFC to eight out of nine years over 2009 to 2017.
It is another reminder of the intertwining of the fates of Australia and China.
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