17 July 2019
China needs to counter any expectations for long-term depreciation of its currency. Photo: Reuters

Yuan in correction phase, rather than long-term slide

Where is the bottom line for the yuan’s depreciation? My bold guess is the Chinese currency will hover in the range of 6.7 and 7.0 against the US dollar in the onshore market until the end of this year. Meanwhile, the price spread between onshore and offshore markets will persist.

The redback once tumbled to a five-year low against the US dollar early in 2016. Beijing has repeatedly stressed that speculators won’t succeed in short-selling the yuan, and that China won’t try to beef up its competitiveness through a currency war.

Broadly speaking, China faces huge capital outflow pressure. By the end of 2015, Chinese companies had a total of US$1.5 trillion debt, of which more than 70 percent constituted short-duration liabilities.

In the meantime, the country has seemingly slipped into a deflationary phase, and the government is set to further ease monetary policy to stem deflation. By contrast, US interest rate is on the rise, and the rate gap between both nations is narrowing. Amid this situation and expectations of further weakness in the yuan, more capital would flee China.

Most assets held by Chinese families and companies are denominated in yuan. The private sector is likely to switch more assets into US dollar in light of the dollar strength. That would put pressure on the Chinese currency. One should also note that correlation between the equity market and currency will accelerate the depreciation and ignite speculative trades.

Now, we come to this question: will the Chinese central bank allow deep yuan devaluation? If it does so, huge amount of capital will flee the country. Chinese companies have considerable dollar debt.

Meanwhile, multi-national companies that have accumulated huge profits in China during the currency appreciation in the last few years, might transfer their profits back to their home nations. That might further exacerbate the market sentiment.

The central bank needs to let the yuan move two-way, instead of heightening one-way devaluation expectation. Otherwise, that could trigger massive capital outflow and threaten the financial system stability.

Meanwhile, we should also bear in mind that most of China’s foreign debt is dominated in US dollar. The market is closely watching the movement between yuan and dollar, although the Chinese unit has been stable against a basket of major currencies.

Currently, China is going through a painful restructuring process. If the nation’s exports improve in the second half, the economic growth rate could stabilize above 6.5 percent, which would help stabilize the redback.

The yuan has not depreciated rapidly against a basket of currencies. Over the last couple of years, euro, Japanese yen and emerging market currencies have all fallen sharply against the dollar. By contrast, the yuan has even been overvalued based on a basket of trade weighted currencies; the unit has weakened only against the dollar.

All this said, the Chinese unit may remain volatile in the next six months. The currency has no basis for further deep depreciation if we look at two years or even beyond. Recent depreciation is just a correction after long-time appreciation.

The central bank has been aggressively attacking short-sellers. But it looks like a tough job given that the nation is facing huge capital outflow and stalling economic growth. It’s quite difficult to reverse the trend anytime soon.

Beijing is hoping for a gradual and managed appreciation of its currency against the dollar. I believe the yuan may lose 5 to 6 percent against the US unit this year, and will move within 4 to 6 percent against a basket of currencies. The central bank is set to intervene if the fluctuation is over 10 percent.

If the yuan fell rapidly to 7-level or even more against the dollar, it could trigger strong expectation for further weakening. That would lead to massive capital outflow and exert huge financial risks.

In the long term, the exchange rate will be determined by economic fundamentals in both the US and China.

This article appeared in the Hong Kong Economic Journal on Jan. 18.

Translation by Julie Zhu

[Chinese version 中文版]

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Senior investment banker

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