Will the Yuan’s Fall Force China to Re-energize Reforms?

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Minyuan Zhao and Avery Goldstein discuss the yuan devaluation

China’s move last week to allow the yuan to shed value by nearly 3% against the U.S. dollar is a step towards market-determined currency rates, although stability remains doubtful. At a broader level, the devaluation trains attention on China’s growth model and the unsustainable practices it needs to unlearn, say experts.

Between Tuesday and Thursday of last week, China’s central bank — the People’s Bank of China — allowed the yuan to fall to its lowest level against the dollar in four years. The bank typically controls the currency’s movement by permitting trades within a specified range of a reference rate it sets daily.

The yuan’s devaluation caused a selloff in global stock markets and commodity markets, triggered by fears that China could launch a currency war to boost its sagging exports. However, the central bank intervened on Friday by raising its reference rates in an attempt to prevent a panic downward spiral.

Then on August 18, the markets responded negatively again. The yuan, which had been slipping further since the initial devaluation, dropped a further 0.2%, a move that came in tandem with a 6.2% plunge in the Shanghai Composite index. The fundamental concerns trace back to uncertainty over the state of China’s slowing economy. And given the sharp drop in the equity market, concerns grew that the currency could fall further.

Piecing together the reasons behind the government’s original action, meanwhile, brings out a number of diverse views.

Reading into the Fall

“Strip away the rhetoric, and the devaluation is in response to the miserable July trade figures,” said Marshall W. Meyer, Wharton emeritus professor of management and a longtime China expert. In July 2015, Chinese exports fell 8.3% over those of a year ago — the worst in four months — with depressed demand from Europe and the U.S., and was far worse than the 1% fall economists had predicted. “The intent is to jump start the export engine. Whether it will — given soft global demand — is an open question,” Meyer noted.

“Devaluing the currency is the easy way out; it immediately makes exports more competitive,” said Mauro Guillen, Wharton professor of international management and director of The Lauder Institute. China had been losing ground due to rising wages and to competition from other Asian countries, he explained. “China needs to rely less on exports and more on domestic consumption. That’s the essential structural shift.”

“Strip away the rhetoric, and the devaluation is in response to the miserable July trade figures.” –Marshall Meyer

According to Wharton management professor Minyuan Zhao, the risk of a downward spiral in the yuan’s value is for real. With interest rates in China being higher than in the U.S., many Chinese companies have borrowed heavily in U.S. dollars, and many western investors have parked money in China for the short run, she said. “The moment they sense a depreciation, all this money will go out.

“As a result, [outflows from China] will create an even larger devaluation than intended by the government,” added Zhao. It was precisely because of the fear of that occurring that the central bank intervened to stabilize the currency, she noted. “Everyone in the government in China is now speaking positively about the currency because there is a [likelihood of a] fear-induced downward spiral.”

Does the devaluation sufficiently strengthen China’s case to make the yuan a reserve currency? “The optimistic version is that this shows China’s willingness to move away from a quasi-fixed rate, which is of course a prerequisite to being a reserve currency in the current system,” said Jacques deLisle, professor of law and political science at the University of Pennsylvania Law School and director of the Center for East Asian Studies.

However, deLisle did not see much merit in that view. “This is the latest in a series of actions that [demonstrate] a policy approach that shows a quick trigger for interventions in markets when things seem not to be going in the direction policy makers want,” he said. “That is not the mindset for moving to a more market-accepting approach to currency valuation.” He pointed also to recent interventions by the Chinese authorities in containing a stock market slump.

China Bashing Ahead?

China’s perceived manipulation of its currency will become an issue in the forthcoming U.S. presidential elections, according to Avery Goldstein, University of Pennsylvania professor of global politics and international relations. He noted that the U.S. government and Congress have pushed for a market-determined rate for the yuan for many years. “They believed, probably mistakenly in the last few years, that China’s currency was undervalued. Now, the discovery is maybe it was overvalued,” he said. “Yet, despite that, the political reality in the U.S. is this reaction that China is manipulating its currency — and devaluing its currency in order to gain an advantage.”

Goldstein expected “serious political repercussions in the U.S.,” even if they are detached from the economic fundamentals. “People will engage in China-bashing on currency and trade issues.” On the other hand, if the swings in China’s currency value are modest, “over time, the markets will adjust and the American electorate will adjust as well.”

Goldstein also foresaw “knockoff effects” in terms of the support for the Trans Pacific Partnership (a trade agreement between Pacific Rim countries), which is up for final ratification by the end of this year. When Chinese president Xi Jinping visits the U.S. in September, Goldstein expects President Obama to “lay down the line with President Xi about currency manipulation.”

(Zhao and Goldstein discussed the ramifications of the yuan’s devaluation on Wharton Business Radio on SiriusXM channel 111. Listen to the podcast at the top of this page.)

Mixed Signals

How far China will loosen its control over the yuan’s value is a matter of speculation. Zhao said one could read the depreciation of the yuan in two ways. While the Chinese central bank has characterized it as a move to let the market determine the currency rate, others see it as part of a larger plan by the central bank to devalue the currency.

In any event, the yuan has witnessed downward market pressure for a long time, while the central bank has tried to prop it up, Zhao said. She noted that the yuan has been trending downwards in daily trading over the past six months, but the central bank has intervened each time to artificially raise the rate the following day, only for the markets to push it down again.

In China, “the market sentiment will be determined by what the government says, because ultimately it is the biggest player in the market.” –Minyuan Zhao

Meyer saw money supply as a prime culprit undermining the yuan’s value. The growth in money supply in China has ranged between 13% and nearly 30% in the 15 years between 1995 and 2010, according to World Bank data. After clocking 28.4% in 2009, it started to drop steadily, and was down to a modest 13.6% in 2013 and 11% in 2014.

“The inflection point is 2009, where M2 [money supply] takes off like a rocket, growing much faster than GDP,” Meyer noted. “There is no way a currency can continue to appreciate without props when the money supply vastly outpaces GDP, and the problem is compounded when the driver of GDP — investment — is increasingly unproductive.”

Is China on the right path with the devaluation? “The fixed exchange rate is a like a beer bottle — not a floating balloon [where] you feel the pressure inside,” said Zhao. “Being a beer bottle for so long, you don’t know what the pressure is inside. People talk of the downward pressure, but you don’t know how big the pressure is until you let go. If the market goes outside control, the market can go on a downward spiral — fear can trigger more fear, and that is certainly not healthy for the economy.” In any event, she noted that the Chinese central bank has enough ammunition to intervene in the market and prevent a downward spiral of the yuan.

Reserve Currency in Question

Zhao noted that the Chinese government has been inducing confidence in the currency in a “stability versus market-valued calculation.” That, she explained, is in light of the International Monetary Fund meeting coming up in October that will determine whether the yuan can be included as an international reserve currency.

Will the devaluation improve China’s chances at that meeting? According to Guillen, the devaluation “undermines China’s case because it shows that the RMB is not freely exchanged, but manipulated by the government.” Meyer, too, did not think the devaluation strengthens China’s case with the IMF. Money exiting the country has been one big problem. Here, Meyer said China would have to tighten controls on capital outflows to keep its banks liquid. He pointed to the recent increases in interbank borrowing rates as an indication of liquidity constraints.

However, China faces a dilemma in meeting the IMF’s criteria for inclusion as a reserve currency, Zhao said. “To join [that club], there are two criteria. One is a stable and a strong currency, and the second is a market-determined currency — which at this point [in China] do not go hand-in-hand, because the currency has been artificially propped up to look strong.” If China allows the market to determine the yuan’s rate, it will continue to go down, she said. At the same time, if the government wants its currency to be stable, the central bank has to intervene, she added. “How the Chinese central bank will play on these two cards will be interesting to watch.”

Impact on Asia

In 1994, when China devalued its currency in the wake of the Mexican peso crisis earlier that year, the move hit Asian economies hard and is thought to have contributed to the Asian financial crisis of 1997-1998. Now, with the U.S. Federal Reserve expected to raise rates in September, the Chinese devaluation could again hurt Asian economies, according to market watchers.

Guillen agreed that the devaluation hurts China’s competitors in Asia. “It also makes the Fed’s plan to raise interest rates more difficult because that would further strengthen the dollar,” he said. However, the big losers are commodity exporters in Latin America and Africa because commodity prices will go down (in dollar terms).

Meyer did not expect to see a repeat of the 1997-1998 Asian financial crisis. The magnitude of the current devaluation so far is much smaller — 5% versus 30% in 1994. “I don’t think people will rush to invest in China given the perceived weakness in their economy and the glut of manufacturing capacity,” he said. “Still, China’s neighbors won’t be happy.”

Containing Volatility

According to Guillen, volatility in the yuan’s value will continue. “Currency wars do not end just like that. Each action creates a reaction…” Goldstein, meanwhile, did not expect a “dramatic devaluation” in the yuan over time, “because the government promises to prevent that from happening.” He did not see the move benefitting exporters. “The first few days of devaluation are nowhere near large enough to have that effect,” he said.

“[China’s GDP growth] has been driven by fixed-asset investment, not investment in people.” –Marshall W. Meyer

Zhao said she did not understand why people in the past two or three years believed that the Chinese currency was undervalued. “These people did not read the market signs at all,” she said. “There was a lot of pressure. The outward flow of capital is scary.” Net capital outflows from China over the past four quarters total $450 billion, according to a Bloomberg report.

Zhao added that China could avoid another round of devaluation. “But the irony [is in] letting the market determine the exchange rate, because the biggest player on the market is the central bank,” she said. The central bank has been dipping into its foreign exchange reserves to prop up the currency, she noted. “So the market sentiment will be determined by what the government says, because ultimately it is the biggest player in the market.”

The recent stock market collapse has made the Chinese government wiser, according to Zhao. “The government was burned by the stock market crash. They saw how scary the market panic can be and have learned a lesson. They have tried to avoid that in the foreign exchange market.”

Meanwhile, according to Goldstein, the Chinese government, through the People’s Bank of China, will take steps to soften the blow that the devaluation will cause. Guiding that will be the Chinese Communist Party’s desire to demonstrate stability, he explained. “That will be top priority on their minds, and pressure from the international financial institutions and the U.S. Congress is not going to shake the determination of the leadership in China to adopt the policies they think will preserve the stability they want, even as they pursue the reforms they also need,” he said.

Structural Reforms

For China to rebalance its economy in line with the changing realities of slower growth, it needs to address many structural impediments, according to deLisle. Here, he referred to the economic goals the Communist Party of China outlined at its plenum in November 2013. Legal reforms in several areas included leveling the playing field among different types of enterprises, enterprise management and governance, a transition to increase mixed ownership of entities, and market mechanisms for allocating capital, he said.

Meyer pointed to some structural obstacles China needs to address for its new reforms to have meaningful outcomes. He pointed out that since 2009, China’s GDP growth has been investment-driven. “It has been driven by fixed-asset investment, not investment in people.” As a result, China has excess manufacturing capacity, which has caused declining profitability, especially of its state-owned enterprises, and declines in the purchasing managers’ indices that reflect business confidence, he added.

“What you are asking people is to change the way they do business in China, politically and economically.” –Avery Goldstein

Meyer identified the chief issues China has to address if it has to strengthen its reforms drive: “It will take determined leadership and forbearance of the Chinese people to undo these distortions. The big question is whether China can endure tough times to accomplish what must be done — to become a service-based rather than a manufacturing-based economy, and a consumer-based rather than an export-based economy.”

Changing Business Ways

According to Zhao, the currency issue is just one aspect of “a broader discussion on the new business model China has to adopt.” Pressure has been mounting to change the way business is done in China, she said. She referred to the explosion last Thursday in China’s northern city of Tianjin that left 112 dead, at last count. “This is one incident, but it reflects a deeper problem of the way of doing business,” Zhao noted. She identified the problem as a “push for speed and scale, [while] compromising on safety and security.”

Goldstein recalled the Chinese Communist Party’s call at its November 2013 plenum for a shift in focus from the quantity of growth to the quality of growth. With the resulting slowdown, the Chinese people had to recognize that “rapid growth rates, rapid increases in the standard of living, may be a thing of the past,” he said. The shift in focus needs to result in improved consumer product safety and fewer industrial accidents, he added.

Goldstein also saw a need for China to change the incentive structure for officials at the provincial level and below. “You have to stop evaluating cadres of officials at lower levels based on growth,” he said. He noted that the government did talk of changing those evaluation norms. “Now it has to happen in practice,” he said. “It’s tough. What you are asking people is to change the way they do business in China, politically and economically.”

Looking ahead, Meyer hoped the yuan’s volatility is a short-term phenomenon. “However, if China gets a reputation for unpredictable behavior, then all bets are off. I’d ask the Chinese leadership to think of what’s good for the Chinese people rather than GDP. And China may need the world’s help to pull it off.”

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