Weak growth and intensifying deflationary pressures have caused Chinese officials to worry that the strong renminbi is damaging the economy. Hence, some market players predict that China might join the ‘currency wars’ by devaluing the renminbi. We disagree. The move on 11 August 2015 to change the daily fixing’s calculation, which resulted in a devaluation of the renminbi against the US dollar and rattled global financial markets, should not be seen as kicking off a full-blown policy of devaluation. Rather, it should afford market forces a greater part in renminbi trading as part of ongoing economic reforms.
The downside of devaluation for Beijing
Our base case is that Beijing will continue to resist any temptation to devalue because:
- It would not significantly help Chinese exports and economic growth
- It could destabilise capital outflows by creating expectations of further RMB weakness
- It could exacerbate the financial burden of those Chinese companies with large and unhedged foreign currency (mainly USD-denominated) debt.
If China were to join the currency wars, it could trigger competitive devaluations in Asia since a growing number of currencies there closely track the renminbi, increasing the correlations between the renminbi and the major Asian currencies and effectively creating an Asian renminbi bloc of countries that trade with China or are part of the supply chains centred on China.
Devaluation: fanning the flames
These countries have a stronger incentive to minimise any exchange rate volatility and currency risk of their currencies against the renminbi than against the US dollar or the euro since severe swings in foreign exchange markets would have a direct impact on local foreign direct investment, trade and growth.
A corollary of China engaging in competitive devaluations would be that:
- It could exacerbate the Asian currency wars
- It would be bearish for commodity currencies, which track Chinese demand
- Market volatility would be bullish for US Treasuries as capital flows headed for a safe haven
- The downward pressure on global interest rates would increase.
Last year, we warned about the renminbi devaluation risk and argued that devaluation would not be the best option for China. We still don’t see Beijing going down that road.