Yuan’s steep drop poses major risks for Chinese, global economies

The 1979 film “The China Syndrome” dramatized a fictional nuclear power plant meltdown that had the potential to burn its way to China.

Since the film’s release, the expression “China Syndrome” has been associated as a generic catchphrase to describe catastrophic events. As we enter 2017, China is facing its China Syndrome moment with regard to its currency — the yuan.

China’s currency has made many headlines of late. Global observers have been watching the yuan’s downward movement closely, along with the various responses that China’s policymakers have initiated to shore up its value.

{mosads}Over the past year, the Yuan has gone from 6.2¥ per U.S. dollar to around 6.8¥ to the dollar. Soon, the 7¥-to-dollar threshold will be tested. The 7¥-to-dollar ratio is a psychological hurdle signaling a further path of yuan weakness in the months ahead.

Why should we be concerned? What can we make of this development and what does this tell us about the state of the Chinese economy?

To get an understanding of this, we need to explore how China’s currency went from being one of the world’s undervalued currencies to being one of the most overvalued.

Starting with the 2008 financial crisis, the U.S. Federal Reserve has initiated several rounds of “quantitative easing,” or large scale asset purchases.

With each round of quantitative easing, the Fed flooded the market with dollars and pulled down the rate of interest. As a result, opportunistic investors borrowed in the United States at 2 percent, then lent the money out in China at 10 percent, locking in the spread as profit.

In the world of finance, this is known as a “carry trade.” Borrow in a low interest jurisdiction and “carry” the money to a high interest rate jurisdiction to capture profit.

What was the size of China’s carry trade from 2008 forward? Various estimates have placed this number somewhere between 1.5 and 2 Trillion USD. The size of this carry trade is unprecedented in size and scope.

Who executed these trades? Mostly domestic Chinese non-bank financial institutions and a host of U.S.-based financial institutions.

So, what’s changed? This trade can only succeed when interest rates in the lending currency are low and the value of the borrowing currency is stable. Any movement in interest rates or currency values will unravel such trades.

The trade started to unwind in August 2015 when the Fed indicated it was going to start raising its federal funds rate. Quantitative easing would revert to quantitative tapering.

In 2016, the Fed began to indicate future rate increases were in play. President-elect Donald Trump has made it very clear that he wants to see the Federal Reserve continue on a path toward higher interest rates.

Exchange rates are determined by the laws of supply and demand. Over the past twenty years, demand for the yuan skyrocketed as a result of increased trade with, and foreign direct investment (FDI) into, China.

With respect to trade, when companies, such as Walmart or Apple, purchase items from their China-based suppliers, they wire dollars to China and exchange them for yuan. With every container of goods shipped, more yuan is needed to pay Chinese vendors, pushing up demand for the yuan on a continual basis.

With regard to foreign direct investment, when a company, such as Starbucks, wants to open a new store in China, it also needs yuan to support its expansion there. With each new store opening, more dollars are exchanged for yuan, pushing up the demand for yuan.

Over the past decades, both trade and FDI have been strong drivers of demand for yuan, which would imply a strengthening yuan in the long run. 

Today, a reverse flow is occurring. If you are dumping yuan and demanding more dollars, the value of the yuan goes down relative to the dollar. The yuan cannot escape the laws of gravity, as individuals and institutions flood the market with yuan and exchange them for dollars, pushing down the value of the currency.

Now we have a catalyst in place. Higher U.S. interest rates will force an acceleration of the unwinding of China’s massive carry trade. Loans will be called and Chinese corporates that borrowed will find that their borrowing costs are rising — it will now cost more yuan to pay back their dollar denominated loans.

Borrowers in China now have to exchange their yuan and buy dollars in order to pay back their obligations. As a result, there are more yuan flooding the currency market and an increased demand for dollars. 

Have we seen this movie before? Yes. Aspects of China’s currency dilemma are eerily similar to patterns demonstrated during the Asian Financial Crisis of 1997, the Mexican Peso Crisis of 1994, and the Russian Ruble Crisis of 1998.

During those crises, a predictable set of events led to a full-scale financial crisis. As such crisis unfold, wealthy families and the propertied elites are the first to recognize the reduction in their net worth and quickly get their assets out of a declining domestic currency. Capital flight ensues.

Second, corporates also recognize the decline in value of their domestic assets, creating a greater motivation to move assets offshore through acquisition of foreign companies or cross-border mergers and acquisitions.

Third, individuals and institutions that borrowed in foreign currency, such as dollars, face higher borrowing costs and are forced to accelerate the repayment of dollar debts.

Taken as a whole, enormous downward pressure on the domestic currency is exerted as individuals and institutions dump their local currency assets and exchange them for foreign currencies. In all instances, people took their money to the United States.

In recent months, China has taken measures to both stabilize the yuan and reduce the pressure toward greater devaluation. To prop up the yuan, the People’s Bank of China (PBOC) has been intervening in the currency markets by buying up excess yuan.

In order to buy up excess yuan, the PBOC have tapped into their massive dollar reserves and sold dollars while simultaneously buying yuan. This program has been very expensive for China.

To date, it is estimated that China has burned through over $700 billion of its $3 trillion-plus dollar reserves. This has set a negative feedback loop in motion with increasing levels of capital flight depressing the value of China’s domestic currency, followed by the government selling dollars to defend its home currency.

China’s latest response is to rejig the mix of currencies that are held in the currency basket used to determine the yuan’s daily trading range. Roughly one-third of this basket was previously allocated to the U.S. dollar.

China has reduced the dollar’s proportion in the basket and given greater emphasis to other currencies, including the Saudi rial and Polish szloty. In addition to capital controls and restrictions on dollars purchases, this is another policy measure instituted to support the yuan and stem the flow of dollar reserves.

This measure, however well-intentioned, will not do much to relieve continuing downward pressure on the yuan. The move is akin to a student choosing to enroll in a course with an easy-grading professor, rather than a professor known to be a hard grader.

The unforgiving grader, in currency terms, is the U.S. dollar. It is the world’s reserve currency and the standard by which many global currencies are measured against. At best, such a move will be another finger in a dyke that is already bursting at the seams.  

Given this state of affairs, one may say, “So what?” Wouldn’t China benefit from a declining currency making its exports cheaper in global markets?

The answer is both yes and no. China’s exports would certainly benefit from a cheaper currency. 

The downside to a cheaper yuan is that all of the inputs and raw materials that China needs source from foreign countries would be that much more expensive — negating any added benefits of increased exports.

The biggest advantage that China had with regard to its exports was its seemingly endless pool of cheap labor. In actuality, the cheap labor advantage of China disappeared years ago.

There are places in Asia, such as Vietnam and Bangladesh, where labor is one-tenth the cost of labor in China. It has been estimated that Mexican labor is now cheaper than labor in China, with the added benefit of being much closer to the U.S. 

2017 is going to be a challenging year for the Chinese economy. Expect to see further pressure on the yuan and more aggressive efforts on the part of Chinese policymakers to stem the outflow of dollars from its dollar reserves.

China faces a number of choices, all of which portend greater volatility and pressure on its economy and currency. In the meantime, yuan bears smell blood in the water, placing big bets on the decline of the currency.

China has made several attempts to beat back the speculators with concentrated bursts of overnight yuan purchases, leading to momentary spikes in the value of yuan against the dollar.

When bad things happen in the emerging markets, there is a consequential flight to safety. As a result, expect to see increased demand for the dollar and a period of dollar bullishness. 

 

Arthur Dong is a professor at Georgetown University’s McDonough School of Business. He specializes in legal and business engagements between China and the United States. 

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