Is China joining the currency war?

25 Jan 2017

War should be the politics of last resort. And when we go to war, we should have a purpose that our people understand and support. – Colin Powell


  • Among its Asian peers, the renminbi has dropped the most against the USD recently and aggravated Asia’s economic challenges in the face of a strong USD. Is China finally joining the currency war, as many critics have long argued for?
  • A sharp devaluation of the renminbi would not work as the proponents expect. It would backfire on China’s structural rebalancing process and increase international trade tension, encouraging protectionism when global growth is stuck in a low gear.
  • The fall in the RMB-USD cross-rate has been a result of market forces from capital flows and Beijing’s tactical FX policy shift between targeting the USD and the trade-weighted exchange rate. It is not, in my view, a harbinger of China joining the currency war

The USD has risen steadily since the US Federal Reserve started to scale back Quantitative Easing (the taper tantrum) in late-2013. Subsequent Fed rate hikes and the victory of Donald Trump in the US presidential elections have accentuated the USD bull-run (Chart 1). As a result, most Asian currencies have fallen, with some more sharply than others, against the USD with the renminbi dropping the most.

Squeezing Asia

In the past when the renminbi was held steady against a strong USD, Asia’s currency depreciation provided a competitive boost to the regional economies. Since the 1998-99 Asian Financial Crisis, there have been three periods of sharp Asian currency depreciation: the bursting of the US high-tech bubble in the early 2000s, the US subprime crisis in 2007-08, and the sell-off around the 2013-14 US taper tantrum. In each of these cases, the renminbi either stayed put or continued to rise when the Asian currencies fell sharply against the USD.

However, this economic boon has turned into a bane this time, as the renminbi has led the currency sell-off in Asia and squeezed the competitiveness of Asian exporters. The rule of the game seems to have changed, prompting suspicion that China might have finally succumbed to the pressure of currency devaluation after holding out for so long.

Devaluation – be careful with what you ask for

Despite recent changes in the capital flow dynamics in China’s capital account, renminbi devaluation is still not in China’s best interest. Devaluation could backfire on China, which is the world’s second largest economy that runs one of the world’s largest trade surpluses. Developing economies that devalued successfully were much smaller in size, so the global system could easily absorb the increase in their exports. They also devalued after their overvalued currencies had caused persistent large current account deficits.

There is no evidence for an overvalued renminbi. Rather than boosting growth, a weak currency makes a current account surplus country more precarious. This is because in deficit countries, where the shortage of domestic savings forces them to fund domestic investment by foreign savings, slowing growth destroys confidence and scares off foreign capital. This contraction in foreign funding, in turn, forces domestic investment to fall. Currency devaluation may help offset or cushion this negative impact on growth in deficit countries by increasing savings.

Devaluation reduces real household disposable income and, hence, consumption, so that its share of GDP falls. By the definition of national income accounting, the share of savings must rise. Typically, this happens when the devaluation increases the profitability of the tradable goods sector (i.e. exports), which increases the saving of this sector (in addition to the increase in household saving due to the fall in consumption). In other words, currency devaluation redirects income from consumption to savings. The rise in domestic savings reduces the country’s dependence on foreign capital and, thus, boosts investment even when foreign inflows decline.

However, devaluation does not work for surplus countries the same way because they do not suffer from saving deficiency; and China’s national savings are excessive at 50% of GDP. Devaluing the renminbi would thus depress the already-low domestic consumption and increase the country’s already-excessive investment and reliance on exports to release the excess capacity. The point is that for surplus countries, devaluation replaces consumption demand with investment demand and trade surpluses.

From China’s perspective, this result would certainly go against the purpose of its economic rebalancing from investment-led to consumption-led. So Beijing should resist renminbi devaluation. But keeping a stable, and dear, renminbi also means pains for China’s export sector, especially when it is losing the advantage of cheap labour cost to its Asian neighbours. Well, this is typically the cost of structural rebalancing, and a bullet that Beijing has to bite.

From a global perspective, in a world with growing trade tensions and persistent weak demand, if Beijing were to pursue a devaluation policy, it would likely ignite more currency wars, encourage trade protectionism and risk turning back the process of globalisation. Hence, even though strategic positioning argues that Beijing should choose to join the currency war, practically it has not and will not.

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