A tough balancing act for China’s economy

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TA01247KUCHING: Asia’s biggest growth engine, China, is juggling between long term sustainable economic growth and moving its currency widely known as the remimbi or yuan towards internationalisation.

Baffaled by slower economic growth, the People’s Bank of China (PBoC) recently devalued its currency – the yuan – in an attempt to spur exports and signaled the move towards a more market-based determinant exchange rate.

“The reform of (yuan) exchange rate formation mechanism will continued to be pushed forward with a market orientation.

“The market will play a bigger role in exchange rate determination to facilitate the balancing of international payments,” it said in a statement.

Market observers say the move was initiated as an effort to stimulate the economy by encouraging exports and raise the country’s gross domestic product (GDP) growth.

Philip Futures Sdn Bhd derivative products specialist David Ng noted, “We believe that weak growth has played a role in the decision.

“We do not believe that the move constitutes a fundamental change in China’s exchange rate strategy.

“It makes little sense to now change a strategy that aims to bolster growth via depreciating exchange rate,” he told Biz Hive Weekly in an e-mail.

While Chinese exports have been weak, Ng said the scenario came against the backdrop of soft global demand.

Ng noted that until recently, trends in China’s share of global exports have not suggested a loss of competitveness.

“Put differently, growth in China is mainly slowing for structural reasons and not because of an over-valued currency.

“Such a large devaluation could have adverse confidence effects, however, weighing on net capital flows on both the inflow and outflow sides.

“As a corollary, this could create a perception of the yuan not being “fit” for Special Drawing Rights (SDR) entry.

“Hence, the move (yuan devaluation) should help China’s SDR ambitions, but a large and seemingly uncontrollable depreciation would likely hurt the same,” the analyst opined.

Concurring with Ng, some economists believe the market-based reforms would boost China’s campaign for the yuan to be included in an elite grouping of currencies used by the International Monetary Fund (IMF).

They noted China has a desire for the yuan to be included in the IMF’s  SDR basket, which the organisation uses to value reserve assets.

Currently, the basket currencies include the US dollar, European euro, British pound and Japanese yen.

The inclusion of the remimbi or yuan in the IMF’s currency basket would provide significant credentials to the yuan, they added, which is increasingly being used more often to perform international transactions and payments.

Meanwhile, PBoC’s move to devalue the yuan has caught the financial markets by surprise with The Wall Street and major Asian bourses slided into the red.

The move has sent financial markets into a wild spin amid concern that other countries in the region could follow China’s move to devalue their currencies which could lead to a potential ‘currency war’.

Nonetheless, the PBoC has defended its move citing that the policy change was initiated to allow more control over the currency in the future.

Subsequently, Chinese Premier Li Keqiang during an event in Beijing in late August has described the PBoC’s move as an “appropriate response” to developments in international financial markets.

He believed there was no basis for the yuan to weaken further and the exchange rate would be maintained at a “basically stable” level.

“The exchange rate would be kept “basically stable” at an adaptive and equilibrium level,” Li told Xinhua news agency.

While the devaluation of the yuan could mean cheaper Chinese goods and products abroad, will it be able to generate sustainable long term economic growth?

 

Short term pain?

Certain quarters argued that the devaluation of a currency could affect the standard of living for the citizens in the home country.

It explained that when a central bank announced a loosening in its monetary policy, participants in the foreign exchange market will response through selling the domestic currency, in this case, the yuan, for other currencies in particular the US dollar, thus leading to domestic currency weakness.

On the other hand, businesses – especially exporters – will find it appealing to boost their exports.

While exporters are set to benefit in terms of improved profits through more sales of goods overseas, the citizens of a country could get fewer real imports for a given amount of real exports.

It pointed out that while the country is getting wealthier in terms of higher exports, it is getting poorer in terms of real wealth, for example in terms of goods and services required for maintaining the people’s life and well being.

Over time, the effects of loose monetary policy could trickle down into prices of local goods and services and as a result, the higher cost operating environment could affect the exporters’ profits.

It further rationalised that adjustment of domestic prices and wage rates created by devaluation of a particular currency would require a certain period of time.

As long as the adjustment process is yet to be completed, the situation is favourable for exporters and importing is discouraged.

During the process, it observed that citizens of the country in which the currency is being devalued would be getting less for what they are selling overseas and paying more for what they are buying abroad.

On another note, some quarters opined the devaluation of the yuan could become a game changer for the currency to become a leading international currency in the long run.

Western Kentucky University’s associate professor of economics David Beckworth was reportedly said China’s move to devalue its currency was almost inevitable because the country has been pursuing three conflicting policy objectives.

He pointed out that the objectives are to maintain a fixed exchange rate, exercise discretionary monetary policy and allow free capital flows.

He said,”If a country tries all three objectives, then economic imbalances will build and eventually give way to some kind of painful adjustment.

“China was attempting all three objectives to varying degrees,” he said.

Hence, Beckworth believed something had to give in and in the adjustment process, it was the exchange rate.

He also believed the devaluation is likely to be the first step toward an eventual floating of the yuan.

 

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Measures to liberalise the exchange rate

Sharing similar view with Beckworth, some market observers pointed out the move to devalue the yuan could be a gradual process of financial liberalisation by the Chinese authorities.

They noted Chinese policymakers have been liberalising domestic interest rates and introduced measures for cross-border capital flows in an effort to promote remimbi internationalisation.

They observed that the central bank has also cut policy interest rates and reserve requirements in a series of small steps.

To note, the PBoC had on August 25 cut the interest rates and lowered the amount of reserves banks need to have for the second time in two months.

It cut the one-year benchmark lending rate by 25 basis points to 4.6 per cent, slashing the one-year benchmark deposit rates by the same amount and reducing reserve requirements (RRR) by 50 basis points to 18 per cent for most big banks.

This wass a measure to provide more liquidity into the economy and alleviate the concern of a “hard landing” for the Chinese economy, experts say.

Similarly, analysts projected a continued deceleration for the Chinese economy rather than a hard landing for the Asia’s biggest growth engine.

In the meantime, the latest economic data showed that the Chinese economy continued to remain weak.

The manufacturing purchasing managers’ index (PMI) for August which was released earlier this month fell below the 50 points level to 49.7 points which indicated a contraction for the economy.

Meanwhile, some analysts have cut their forecasts for China’s growth on concern that the second largest economy in the world could be in for a longer period of moderate growth.

Moody’s Investors Services in a recent report said China’s slowdown could be ‘broader than expected’ while projected the Chinese economy to grow at 6.3 per cent in 2016 from its earlier forecast of 6.5 per cent.

At the same time, Goldman Sachs trimmed its medium term economic outlook for China on concern over greater risk of achieving better economic growth.

With a slowing growth, the scenario could affect countries especially from emerging markets that trade with China for instance South Korea, Malaysia, Taiwan and Vietnam.

As a result, currencies of Asian emerging markets reacted negatively after the Chinese central bank announced the yuan devaluation.

 

Devaluation impact on emerging markets

Soon after China devalued the yuan, most Asian currencies which include amongst others the Thai baht, Philippine peso, Indonesia’s rupiah, South Korean won and Malaysia’s ringgit dropped.

The move has further weakened regional currencies which has already depreciated due to capital outflow on potential interest rate hike by the US Federal Reserve.

As a result, the rupiah and the ringgit fell to their 17-year low, a level last seen during the Asian financial crisis.

The ringgit declined by two per cent to RM4.03 against a US dollar while the rupiah depreciated by 1.4 per cent to Rupiah13,788 per US dollar after PBoC devalued the yuan on August 11.

Ng from Philip Futures said the yuan’s devaluation “will definitely cause a ripple for other emerging market currencies including the ringgit.”

“At the same time, the yuan devaluation happened at a time when regional currencies are weakening.

“(Likewise), strengthening of the US dollar will persist until the US Federal Reserve raise the interest rate.

“Thus, devaluation of yuan has caused much impact of emerging currencies but not the dollar index,” he said.

Ng reckoned that emerging markets currencies will continue to be battered partly by currency weakness and it will impact the economic growth to a certain extent.

Despite the weakening currency, the analyst said export competitiveness for emerging markets still remain under pressure as China, the Asia’s economic engine is not churning out fast enough causing weakness across the board.

He opined that the ringgit and the Indonesian rupiah will be affected by such consequences.

In spite of that, Ng believed the yuan devaluation may not have a direct impact for investors as they could change their asset allocation type.

“With persistent weakness in its currency, China investors may look to gold as an alternative investment tool.

“However, gold itself still expose much to the vagaries of the market be it fundamental and technical perspective,” he said.

When asked on the movement of the yuan in the near term, Ng projected the currency to move towards a range bound trading level for the next few weeks pending further action from the Chinese central bank.

He believed until then, the currency movement may be limited.

Apart from that, market observers noted a weaker yuan will increase import costs for Chinese consumers of products such as rubber, coal, and iron ore, thereby reducing demand for commodity exporters from countries like Malaysia, Vietnam and to a certain extent Indonesia as well.

Already, commodity prices such as crude oil and crude palm oil (CPO) have been on downtrend since last year partly due to softening demand from China.

While some Asian countries have let their currencies depreciate as China devalued its yuan, Taiwan and Vietnam have responded by pushing their currencies lower to make exports more competitive.

Taiwan had reduced the rate it pays commercial banks for overnight deposits, lowering down its currency by two per cent then while Vietnam widened the band in which it allowed the dong to trade, which led to some 1.2 per cent decline over three days after China’s yuan devaluation.

Nevertheless, Chinese officials said improving central parity quotation of the remimbi exchange rate is a reasonable response to the trends of the international financial market.

They believed the remimbi has no basis for persistent depreciation and can be kept basically stable at an adaptive and equilibrium level.

 

Yuan gains wider usage

China’s currency is gradually gaining more importance as trades and businesses are poised to grow with the country being the second largest economy in the world.

In a move to enable the remimbi to become a leading international currency in the future, Chinese authorities have taken several steps to open up its financial markets.

One of those include the devaluation of the yuan to allow market forces to set the rate.

Other than that, China has came out with new regulations recently making it simplier for foreign buyers to tap its trillion dollar interbank bond market.

PBoC in a statement said foreign central banks, sovereign wealth funds and global financial organisations will no longer require pre-approval to trade bonds, interest-rate swaps and conduct repurchase agreements.

Citing data from the central bank, market observers said China’s interbank bond market had 35.3 trillion yuan of outstanding bonds as at end of May 2015, with daily trading volume at 356.5 billion yuan.

They also believed the Chinese government’s recent intervention in the stock market was seen as an effort to convince international community that the financial markets will be managed in a stable and sensible way in order to encourage investors to hold renminbi assets.

Franklin Templeton Emerging Markets Group’s executive chairman Mark Mobius in his blog said the opening of the Shanghai-Hong Kong Connect in the latter part of 2014, which allowed foreign investors to freely invest in eligible Chinese A shares previously restricted to only Chinese citizens was seen as a major move in internationalising the remimbi through allowing mainland investors to acquire stocks on the internationally traded Hong Kong markets.

He observed the situation changed in April 2015 with the announcement of measures to permit mainland mutual fund managers to buy into Hong Kong stocks.

He noted restrictions on the use of Stock Connect by individuals were relaxed and the usage rose sharply to the extent that trading quotas on certain occassions were exceeded.

Recent developments could also enable the Shanghai stock market to become more closely integrated into global financial markets, marking wider usage of the renminbi.

Additionally, recent government intervention in the stock market and suspension of stocks during a sharp market downturn could have an impact on the reform process and the progress made towards renminbi.

Mobius pointed out that the introduction of the planned China International Payment System (CIPS) and setting up a worldwide clearing house for international renminbi payments have made the use of the renminbi easier, putting it more on par with other global currencies.

“International businesses appear to be “voting with their feet” on the matter of renminbi internationalisation.

“In a survey by the Economist Intelligence Unit for international lawyers, some 50 per cent of executives who responded anticipated at least a doubling of renminbi use, while 45 per cent had used the currency in a cross-border transaction in the past year, as opposed to only 21 per cent in the past 12 months.

“49 per cent were planning to use renminbi to fund acquisitions. In our view, further movement toward full convertibility could see the process accelerate,” he said.

He believed the launch of the Asian Infrastructure Investment Bank (AIIB), the New Development Bank (NDB) formerly known as the BRICS bank and CIPS, accompanied by the potential admission of the renminbi to the International Monetary Fund’s (IMF) SDR would clear the way for the currency to become one of the world’s principal reserve currencies.

NDB’s president K.V. Kamath was cited as saying that the NDB will issue its first loan in April 2016 in Chinese renminbi.

“The launch of the NDB is an attempt to create an alternative or at least parallel financial system to the existing dollar one, and the first loan in yuan is a sign of this trend,” he said.

Apart from that, Andrey Kostin, the chief executive officer (CEO) of VTB Bank, Russia’s second biggest bank was reportedly said the Chinese yuan as the leading currency can be used in settlements among BRICS member states adding that the Russian ruble can be used as well.

He believed there will be growing interest from Brazil, Russia, India, China and South Africa (BRICS) to make settlements in local currencies.

Furthermore, China is committed for the yuan to be included in a basket of currencies used to denominate and settle loans from AIIB.

Media reports noted that China would push for broader use of the yuan at the AIIB and the Silk Road Fund, as part of initiatives to promote the yuan as an international currency.

On the domestic front, Bank Negara Malaysia (BNM) governor Tan Sri Dr Zeti Akhtar Aziz believed that Asia including Malaysia must be ready for the increased internationalisation of the renminbi and its potential role in Asia.

She observed the rise of the renminbi although gradual is inevitable with important implications to Asia and the rest of the world.

“BNM would further enhance its financial cooperation with PBoC in the area of Renminbi Qualified Foreign Institutional Investor to provide an alternative avenue for Malaysian investors to invest in onshore Chinese financial markets.

“The settlement of trade and investment in renminbi significantly lowered costs and promote greater cross-border trade and investment activity.

“Malaysian institutions and corporations such as Khazanah (Nasional Bhd), Cagamas (Bhd), Axiata (Group Bhd), and Maybank have issued renminbi bonds.

“With the various renminbi financial infrastructures that have been put in place to support trade, investment and financial flow between Malaysia and China, this trend is expected to increase,” she said at the HSBC Renminbi Forum in Kuala Lumpur recently.

Zeti observed that currently, the usage of renminbi in Malaysia has grown rapidly with the daily size of renminbi foreign exchange volume at 6.7 billion renminbi.

Therefore, she urged Malaysian entities with large regional network to consider using Malaysia as the centre for their regional renminbi transactions, thus help to contribute towards greater economies of scale over time.

She noted with greater economies of scale, it would enable transactions to be conducted in the most efficient and cost effective way.

“More renminbi-based trade within the region will create pools of renminbi liquidity, which would create a demand for instruments.

“(This) would in turn spur the development of more efficient and integrated renminbi capital markets in the region that can contribute towards better intermediation between the surplus and deficit units in the region,” she added.

Likewise, to further promote the usage of renminbi in the settlement of Malaysia’s bilateral trade and investment with China, BNM noted the central bank had in 2009 entered into a currency swap agreement (CSA) with the PboC.

It outlined the agreement which was renewed in 2012 with an expanded amount of 180 billion renminbi is aimed at ensuring a ready supply of renminbi in the domestic financial markets to meet the demand by businesses.

BNM added efforts were also made to enhance the transparency in the exchange rate between renminbi and ringgit transactions.

The central bank noted that in 2010, a direct market quote of renminbi against the ringgit was initiated in the Kuala Lumpur interbank market as well as in the interbank foreign exchange market on the China Foreign Exchange Trade System (CFETS).

With those developments, BNM observed that there is currently a direct renminbi or ringgit quotation in the spot market and a renminbi or ringgit forward exchange rate for the Malaysian market.

“To further facilitate transactions, the real time gross settlement (RTGS) payment system in Malaysia has also been expanded since 2012 to include settlement services in renminbi.

“To facilitate more effective renminbi liquidity management by financial institutions in Malaysia, BNM has introduced a renminbi liquidity facility (RLF) to licensed onshore banks.

“This facility aims to enhance renminbi liquidity in the domestic market by providing an additional avenue for the licensed onshore banks to obtain or invest renminbi with the bank.

“The bank, through its own access to the interbank market in China, will offer these liquidity facilities via the renminbi or ringgit foreign exchange market, and the renminbi money and repurchase markets in the Malaysian interbank market,” BNM said.