Devaluation Promises to Boost Exports, But Adds Stability Risk
China's central bank has signaled a new stage in the management of the yuan and opened the door to depreciation to support export competitiveness. The People's Bank of China adjusted the yuan central parity — the daily fixing used to guide the market — down 1.9 percent today, the largest drop on record. The central bank also said that, going forward, the central parity will closely reflect the market price.
That marks a significant shift in policy, as the central bank ends its eight-month resistance to market pressure for yuan depreciation. The direction of travel from the market is clear. At 6 a.m. New York time, the spot price had already fallen to 6.3250 to the dollar, from 6.2097 at Monday's close.
The PBOC's move reflects the depth of concern about China's growth, which threatens to fall below the government's 7 percent target for the year. Exports contracted 8.9 percent year on year in July as a 14 percent annual appreciation in the real effective exchange rate choked off demand.
The timing likely also reflects concern that as the Fed moves toward a first rate hike, a peg to a rising dollar would mean continued appreciation of the yuan against the currency of trade rivals.
Reviving flagging exports will require a significantly larger depreciation. Exports year to date have been flat from a year ago. Based on our calculations, a 10 percent depreciation against the dollar would take export growth back to 10 percent year on year, all else being equal.
The risk is that depreciation triggers capital flight, dealing a blow to the stability of China's financial system. Our estimate is that a 1 percent yuan depreciation against the dollar would trigger about $40 billion in capital flight.
The calculation from China's leaders is likely that, with $3.6 trillion in foreign exchange reserves, substantial bank deposits stashed in reserve at the PBOC, and controls on cross-border flows, they can manage any risks. Assuming a 10 Spot Price, Central Parity and Trading Band See this story on the Bloomberg terminal with additional charts here. percent depreciation triggered $400 billion in capital flight, they would still be left with FX reserves in excess of $3 trillion.
Years of yuan appreciation increased the appeal of investment in China and had a broad positive impact on asset prices. Yuan depreciation will have the reverse effect. That's a negative for the struggling equity market and the nascent recovery in real estate — where speculative demand plays a major role.
Depreciation will deal a blow to China's hopes for yuan inclusion in the IMF's SDR basket. It will decrease international investors' willingness to hold yuan, and will likely irk the IMF — which has only recently shifted away from its characterization of the currency as undervalued.
There are also political economy considerations. President Xi Jinping is set to meet with President Obama in September. Competitive depreciation of the yuan will not make that conversation any easier. Neither will it improve Beijing's relations with regional rivals Tokyo and Seoul, who fear any gain for China's exporters comes at the expense of lower sales for their own firms.
China likely views any international protests as a manageable second-order consideration. That's especially true as they can legitimately present depreciation as driven by the market, and other major central banks have adopted policies that promote exchange-rate depreciation.
In terms of China's longer-term rebalancing agenda, we give the central bank credit for finding a policy that combines stimulus and reform. A weaker yuan will provide a boost to growth. A more market-set exchange rate is in line with the direction of travel set at the Third Plenum, and will promote more efficient allocation of productive resources.
Looking at the historical data as a guide to the possible extent of coming moves, the biggest three-month yuan move on record was a 4.2 percent appreciation at the start of 2008. It would take a 14 depreciation to take the yuan back to mid-2014 levels, when its latest period of appreciation in real effective terms started.