Tuesday’s rally in the renminbi was triggered by positive noises coming from the White House, raising hopes that the US may open the door to a trade deal with China, perhaps within weeks. The market moves saw the Chinese currency at one point strengthening past the seven-per-dollar mark.
But investor optimism should be tempered. The world’s second-biggest economy remains in a tight spot. Compared with its previous slowdown in 2015, the Chinese economy is in worse shape today. The policies implemented to boost growth are proving less effective.
If a trade deal does not happen, investors should be alert to another competitive depreciation of the renminbi — and a negative reaction in the stock market — as a growing possibility.
To appreciate the differences between now and 2015, consider the following. First, President Xi Jinping is leading a charge to combat excessive corporate and financial leverage, which poses a growing systemic risk to the economy. This focus on deleveraging of the economy was not a feature in 2015.
Mr Xi’s policies have focused on the riskiest parts of the banking sector, notably “shadow banking”, which has long been a major source of credit to the private sector. This includes off-balance sheet lending from banks, peer-to-peer lenders and credit extended by fund managers. Small and medium-sized enterprises, and highly leveraged property developers, have been particularly dependent on this form of financing.
The credit crunch resulting from the government clampdown has pushed up the cost of funding for private companies, weighing on economic growth, and led to a jump in defaults by private companies. China is thus choosing pain today over worse pain tomorrow.
Second, the government’s capacity to stimulate the economy is more limited than four years ago. On monetary policy, the People’s Bank of China is constrained by a resurgence of inflationary pressures, not least from pork prices. These have jumped as a result of the African swine fever epidemic, which has cut the country’s pig population by almost half.
What is more, the central bank’s monetary easing policies do not seem to be passing through into the real economy. Whether those are traditional measures, such as reserve requirements, or new tools, including a supposedly market-driven prime loan rate, they are struggling to have an impact. This can be seen in the spread between bank lending rates to state-owned and private companies, which continues to widen.
Things are no better on the fiscal front, where local governments are increasingly cautious of splurging on more “white elephant” projects, given their high debt levels and growing pension and health liabilities for an ageing society.
Finally, and somewhat paradoxically, a further depreciation of the renminbi is made more likely by the fact that the Chinese government seems to have better control over capital outflows than four years ago.
The lesson from August 2015 was that choosing devaluation as a policy tool costs you a trillion dollars in reserves. But this is only the case if your capital account is leaky enough for money to escape overseas.
Recent history has shown China is able to manage a controlled depreciation of its currency with no loss of foreign reserves, even against a background of market panic each time trade negotiations with the US break down. This should assuage China’s unease about pulling the currency trigger if needed.
With its economy decelerating both structurally and cyclically, and with the usual economic levers of control lacking in strength, the Chinese government would dearly like a trade deal with the US to boost external demand and bolster confidence.
But a comprehensive trade deal may remain elusive for longer than China can afford to wait. Facing this conundrum, Beijing may conclude that a competitive depreciation of the currency, which would boost exporters, is the only way to provide the stimulus the economy needs.
The August 2015 depreciation of the renminbi sparked a stock market rout that cut a quarter off the value of the Shanghai Composite index over two grim weeks. Investors should watch the ongoing trade negotiations carefully, aware that if they falter, China may see a currency depreciation as its least bad option.