During the first half of November the renminbi has been trading around 6.95 against the US dollar (see exhibit 1 below). Financial market observers are apparently worried that it will soon break through the 7/USD threshold. For their part, many investors are wondering whether the People’s Bank of China (PBoC) will defend the ‘7’ from being broken through. In my view, a more crucial question is: So what if ‘7’ is broken?
Exhibit 1: The renminbi has weakened in 2018 and is approaching the level of 7/USD
Source: Bloomberg, BNP Paribas Asset Management, as at 16/11/2018
A choice between two psychological levels
The PBoC can defend the renminbi at 7/USD by draining FX reserves. However, that would soon raise another concern about the sustainability of the intervention. While 7/USD is the market’s psychological ‘break point’ for the exchange rate, USD 3 trillion is the psychological level of China’s FX reserves below which market panic could set in.
This choice between defending the CNY-USD cross-rate at 7 and preventing the FX reserves from falling below USD 3 trillion reflects the policy dilemma of the Impossible Trinity, whereby China has to choose between controlling the exchange rate or the interest rate when the capital account is opened up. Given the increased domestic macroeconomic challenges and external trade war risk, the PBoC has reinforced its preference to relax exchange-rate control by tolerating higher renminbi volatility. Several senior officials have recently highlighted this policy stance.
While we have found no proof of PBoC shifting to a devaluation policy, there has been a shift in its attitude towards tolerating higher renminbi volatility since its decline in June this year. As long as the renminbi’s movement is orderly and driven by market forces, there is no particular exchange rate level that the PBoC feels obliged to defend, in my view.
A renminbi Plaza Accord?
Some players also wonder if China may enter into an international agreement to depreciate the US dollar by revaluing the renminbi. This is what happened with the Plaza Accord in 1985, when Japan yielded to pressure from the US, the UK, West Germany and France to push up the yen to address the huge US trade deficit. Beijing has vowed that it would not pursue such a course.
The Plaza Accord saw the yen surge, prompting the Bank of Japan to pump massive liquidity into the Japanese economy to offset the impact on Japanese exporters. The move led to the building up of an asset bubble in Japan which burst in the early 1990s and has since wrought havoc on its economy. China will not want to make the same mistake. With its closed capital account, stronger economy and more financial prowess, China is in a stronger position than Japan was to resist US pressure to enter into such an agreement.
What if the renminbi breaks through the 7/USD level?
From an Asian perspective, the key concern is that renminbi weakness will add to the economic headwinds, such as high oil prices, tight USD liquidity, US tariffs etc., that the region is facing. Since China is both a competitor and a major market, a weaker renminbi would squeeze Asian exports both to third-party markets and to China. Furthermore, Chinese tourists may be less keen to travel overseas due to dearer foreign exchange, thus hurting the services exports of the other countries.
These are valid concerns, but they should not be exaggerated. Firstly, many Asian currencies have dropped against the US dollar (exhibit 2), with some weakening by more than the renminbi’s decline against the dollar and have thus gained some competitiveness against China. But prices are not everything; export structures also matter. Shipments from those economies with greater currency weakness tend to be more exchange-rate (price) sensitive than exports from economies with less FX weakness.
Exhibit 2: Percentage change in nominal exchange rates against the USD from Jan-Sep 2018
Source: CEIC, BNP Paribas Asset Management (Asia), as at 06/11/2018
For example, South Korean, Taiwanese and Singaporean exports compete on brand, quality and innovation, and are thus relatively price insensitive, and these countries’ currencies have dropped by less against the dollar than the renminbi has. However, Indonesian and Indian exports compete more directly on price and their currencies have dropped by more than the renminbi against the dollar. Thus, not all regional economies will be hurt by a weak renminbi.
Secondly, if renminbi weakness reflects China’s monetary stimulus to help sustain GDP growth at above 6%, the government’s medium-term bottom-line GDP target, the impact of an increase in imports to China may end up helping to offset some of the adverse impact from exchange-rate moves and collateral damage from the Sino-US trade war. Notably, despite the rise in trade tensions, a weaker renminbi and slower GDP growth, China has so far remained a growing market for Asian exports, significantly overtaking both Europe and the US (exhibit 3).
Exhibit 3: Asia (excluding China) export growth
Note: data series in 3 month moving average. Source: CEIC, BNP Paribas Asset Management (Asia), as at 06/11/2018
Strength of China’s demand
Might China’s rise in imports result from higher crude prices, as it is a major oil importer? Not entirely, because most of Asia’s exports to China are non-energy related. Indeed, China’s imports of manufactured goods have risen steadily. It is also unlikely that China was frontloading imports of processing goods (used for exports) to beat the Trump tariffs because growth of its manufacturing process imports has not risen since the trade conflict started (exhibit 4).
Exhibit 4: China’s imports
Note: data series in 6 month moving average. Source: CEIC, BNP Paribas Asset Management (Asia), as at 06/11/2018
- China’s demand has been driving trade growth in Asia, offsetting some initial effects of the Sino-US trade conflict.
- An orderly weakening of the renminbi need not be all that negative for the regional economies. It may even be a benign force for Asia’s growth if the weakness reflects China’s policy easing, which would ultimately help sustain its growth and, hence, its import levels.
Driven by market forces, the renminbi/US dollar exchange rate may indeed break through the ‘7’ mark in the near term. But so what?
 See “Chi Time: Collateral Damage of the Sino-US Trade Conflict”, 10 October 2018.