Will China Join the Currency Wars?

May 4, 2015 Updated: December 9, 2015

For years we have heard the Chinese currency is undervalued relative to the U.S. dollar and should appreciate. This is no longer true and China might actually have to devalue.

China manages its exchange rate. It is currently pegged to the U.S. dollar at a rate of roughly 6.20 yuan per dollar. Every time the exchange rate fluctuates too much, the central bank of China intervenes in the markets to bring the rate back to where it wants it to be.

Managing the exchange rate this way has helped China to compete in global export markets and accumulate trillions of dollars worth of foreign exchange reserves. Along with China’s growth, the PBOC has actually also allowed the dollar to drop by 25 percent over the past 10 years, giving up some of this artificial competitive advantage.

China’s real exchange rate … is 15 to 20 percent overvalued compared with 2010, the last time exports grew like topsy.
— Charles Dumas, Lombard Street Research
The U.S. dollar in Chinese yuan has been declining over the last 10 years. (Google Finance)
The U.S. dollar in Chinese yuan has been declining over the last 10 years. (Google Finance)

As a result and also because of lackluster international demand, exports growth has slowed over the past 5 years and even fell this year in March. Because of excess productive capacity and massive debt problems, some analysts now believe the yuan is actually overvalued—and China has reasons to join the global currency wars by actively weakening its currency.

“China’s real exchange rate … is 15 to 20 percent overvalued compared with 2010, the last time exports grew like topsy,” writes Charles Dumas of Lombard Street Research.

China’s exports have also taken a hit because its two main competitor economies (the Eurozone and Japan) have aggressively devalued their currencies against the dollar. The yuan is pegged to the dollar, so it automatically went up with it against the euro and the yen.

Just over the past year, the yuan has gained 25 percent against the euro and 18 percent against the yen. “[They] have left China at a massive cost-competitive disadvantage to its chief rivals in the sluggish domestic demand club,” writes Dumas.

Meanwhile China’s domestic economy (like Europe and Japan) is also slowing dramatically, so it would need to do something to spur growth. “Our preliminary figures suggest the economy actually contracted,” writes Diana Choyleva, Lombard’s chief economist. Official data still shows growth of 7 percent over the 12 months ending March 2015.

Traditionally, China has stimulated the economy through investment in infrastructure and real estate, but it seems this road is not available anymore.

“There is room to grow but I don’t think they can grow investment. I think it’s going to start shrinking sometime soon. It won’t remain at 50 percent of GDP,” Peter Fisher, a Senior Fellow at the Tuck School of Business, Dartmouth College, said during a panel discussion at the Council on Foreign Relations.

China’s officials have openly admitted they want to change the growth dynamics of the country and encourage consumption rather than more investment. In private, officials have cited the decreasing marginal productivity of capital as well as the risk of financial bubbles as arguments against further traditional stimulus.

So is competing in the global currency wars by devaluing the yuan an option for China? The resounding answer is no, for several reasons.

“The issue there is: China wants to become a more credible entity. If you want to be seen as a reserve currency and you want people to have more confidence in investing in your economy you can’t do these kinds of things like a one-off devaluation and surprise people,” said Ellen Zentner, chief economist at Morgan Stanley, at the Council on Foreign Relations.

China is currently lobbying to become part of the International Monetary Fund’s reserve currency, the SDR, so devaluing is counterproductive. Officials in Beijing are also not too worried about falling exports either, as they see a normal export growth rate of 5 to 6 percent.

According to Leland Miller of China Beigebook International, the regime likely won’t worry about slowing exports until unemployment gets out of control.

“The economy is slow, the credit markets are a mess, but surprisingly according to our data, the labor market is very resilient and as long as the labor market is resilient, we’re talking about employment growth, we’re talking about job expectations, and there won’t be any stimulus,” he said.

In addition, sources in Beijing tell us that the regime is actively using the stock market to taper over some of the problems like crashing real estate to keep the people happy. The Shanghai Composite index has more than doubled since the beginning of last year and Chinese people are opening accounts by the millions every week.

According to Leland Miller, this strategy could also end badly: “They are setting themselves up for a stock market crash, we just don’t know when it will happen,” said Miller.