Chinese Currency Faces Critical Test in the Next Few Weeks

Villagers gather to receive their share of 1 million yuan (U.S. $165,000) paid out in year-end bonuses by a tea company at their village in the suburb of Jinan, east China's Shandong Province, Jan. 20, 2014. (STR/AFP/Getty Images)

With the ending of China’s two big political meetings (Political Consultative Conference on March 12 and the National People’s Congress on March 13), the time has come for big and difficult economic decisions concerning the exchange rate. The exchange rate for the yuan is an urgent issue and the Chinese authorities have to decide whether a one-time big depreciation or a gradual depreciation is in their interest. There’s no time to lose.

China’s M2—cash plus highly liquid assets, such as money market accounts—stands at around the equivalent of $20 trillion at the current exchange rate. Much of that money is “hot money” from abroad that is ready to leave China at any moment, so the 3 trillion dollar foreign reserves of China will decrease quickly in the event of a currency crisis.

Now that time is coming: with the introduction of property tax to be an important part of local government revenue and government policies to hold down price appreciation, property prices have started to fall in many cities. In Wenzhou and Hangzhou and other smaller cities, the property bubble (at least three times more serious than U.S. bubble in 2006 in terms of housing affordability) is in danger of a full-scale blowup.

The economy is in a serious downward trend because business owners have to worry about their family safety instead of running their businesses in the current extremely corrupt and dangerous political system, while the state sector is not competitive in the face of foreign competition and is losing market share across the board. 

Now with the two big political shows behind, and Xi Jinping firmly in control, it is time to take some serious steps.

The exchange rate issue is very tricky. A quick depreciation has several clear advantages:

• It can reduce at least part of the potential capital flight: with an exchange rate of 9 (nine yuan to one U.S. dollar) and a promise to hold there, at least 50 percent of possible capital flight should be avoided.
• It can increase the competitiveness of the export sector for at least a few years and give the Chinese authorities some breathing space to reform other sectors of the economy, especially state enterprises.
• It can delay the crashing of the housing market because more international speculative capital in the housing sector will choose to stay in China.
• Xi can use this chance to show he is defiant of U.S. pressure to increase the value of Chinese currency.

A slow depreciation of the yuan would cause confusion and uncertainty. If it lasts for a few months, there is a huge risk to the foreign reserves of China, which Xi could ill afford. 

If a gradual devaluation turns into a sudden crash, Xi will be accused of being incompetent and the financial crisis could easily turn into a political one. 

So the next few weeks will be a critical time to watch for a yuan devaluation. A 40 percent drop is possible.

Warren Song is a New York-based financial consultant.