The Chinese Currency in 2016: Bigger But Smaller

Even more so over the coming decade, America and China, the World’s two biggest economies, will be going head-to-head.  In the background, the relative value of their monies – the Yuan/ US dollar cross-rate – stands as the most important price in the global economy. For years these two units have moved in-step, with the Chinese Yuan tied umbilically to the US dollar in a near-fixed ratio. 2015 has already seen some big changes: 2016 and beyond will see even greater moves. Make no mistake, China is grappling for America’s currency crown. Like medieval kings, much of today’s global economic power comes from seigniorage – the ability to force others to use your paper money – and the US dollar is the unit of choice in most cross-border transactions. But China is playing the long-game: although, in size, America overtook the British economy in 1870, it took another eighty years before the US dollar finally surpassed sterling in international financial markets.

Three things have happened in 2015. First, the US dollar has continued to appreciate significantly, as currency-after-currency from the Euro to the Yen and from the Brazilian Real to the Russian Rouble, and even counting gold bullion, have all tumbled against it. Second, the Yuan has struggled to keep up with the pace. The Chinese authorities signalled a ‘minor’ 3% devaluation last August, dressed-up as a technical adjustment to make the exchange rate more market-determined. Third, in December the Yuan was formally welcomed as the latest member of the IMF’s basket of reserve currencies. This inclusion in the SDR is a political victory for China, but it has come with a significant near-term economic cost.

China wants two things from SDR recognition. She hopes it will encourage the international economy to increase its use of the Yuan. Second, China ability to tap this international demand for Yuan, will help her to get off an unhealthy dependence on the US dollar. The vast markets of Central Asia and Indo-China are ripe for future Chinese economic expansion. This is the next big frontier, equivalent to the nineteenth century American West, and it will be the focus of Chinese economic development over the next few decades. These economies will take-up Chinese aid and credit, but with the result that the Yuan will become a widely used unit and reserve currency within these domains. This is China’s opportunity for seigniorage.

China’s current dollar-dependence is a key reason her economy is currently struggling. There is a growing shortage of dollars in the World economy (and less still when the US Federal Reserve tightens again) and China is going through a ‘cold turkey’-like withdrawal. Forget the stories, based on a misreading of her whopping current account surplus: China’s ranks of prudent savers are simply not bailing out America’s profligate consumers. It is not America that is vulnerable, but China. What is being missed are gross balance sheet positions. China may enjoy a net current account surplus, but she has simultaneously been borrowing huge amounts of US dollars. In short, the peg to the US dollar has effectively dollarized China’s inflating domestic financial markets, and the scale of this bubble is eye-watering. China’s asset economy, courtesy of these dollar debts has grown by a whopping 12-fold since Year 2000, making it the biggest credit and capital spending boom the World has ever seen.

These bubble unwinds are never smooth. The net result is that skittish investors – both foreigners and Chinese – are already accelerating their exit from China: close to US$700 billion has left so far in 2015, or more than twice last year’s outflow of US$270 billion. Some take false comfort from the fact that China’s nest-egg of US$3.5 trillion of forex reserves could cover this outflow for years. Rather, the stark reality is that each dollar that leaves further reduces domestic liquidity, thereby amplifying the on-going domestic credit crunch. Already, lending by the important ‘non-State’ channels that feeds the nascent Chinese private sector is down in absolute terms compared to last year. China’s policy-makers are trying to balance the books by coming down hard on exporters of foreign capital. This will not be enough. Our calculations suggest that the Chinese currency may be already 20% overvalued. It needs to fall. Expect 2016 to see the Yuan fall in value, perhaps by a lesser 5-10%. And, the PBoC’s recent announcement of a Yuan Effective Exchange rate index, which dilutes the weight of US dollar-linked units to just one-third of the basket, makes a devaluation easier. The Chinese currency is getting bigger in importance, but it will first need to get a bit smaller in value to fulfil its destiny.