Freed from the Dollar

In the summer of 1997, one Asian currency after another fell. With the financial crisis in full swing, rumours circulated in Beijing that George Soros had placed a bet with China’s prime minister, Zhu Rongji. It had no repercussions in the currency markets, because Soros couldn’t short sell renminbi, as he had with sterling five years earlier: China’s currency was, and still is, not fully convertible. But Soros is said to have bet $100 million that the People’s Bank of China (PBOC) would not be able to defend the renminbi’s parity with the dollar. It did and he lost. China’s currency has been appreciating ever since – until last week, that is.

The unexpected 4.4 per cent (or more) devaluation of the renminbi is puzzling and so are the intentions of the PBOC. Currency war is one explanation. But in a rare press conference on Thursday, the bank dismissed the idea that this was a competitive devaluation as ‘nonsense’. Starting a race to the bottom is an option for lesser players like the Bank of Japan under the sway of Abenomics (40 per cent devaluation since 2012) or the Eurozone, with monthly QE at €60 billion (the Wall Street Journal calls devaluation ‘Europe’s default growth policy’). In China, the political influence of private manufacturing for export is limited compared to Germany, Japan or France.

A more likely reason for the devaluation has to do with financial flows rather than trade flows. Research from J.P. Morgan showed that against a basket of currencies the renminbi had actually appreciated 12 per cent for the year as a result of its peg with the dollar. Despite trade surpluses close to $400 billion, China has recently been spending for all it’s worth to prop up the renminbi. Just how far the PBOC went to defend the exchange rate against capital flight is reflected in the fall of the country’s currency reserves: by $315 billion in the last twelve months. The dollar is poised to further soar when the Federal Reserve increases interest rates, possibly as soon as this September (the PBOC move might actually prompt Janet Yellen to reconsider the timing of the rise; Goldman Sachs now predicts it will happen in December). Devaluation in this context points to a wish to liberalise and make the renminbi a more flexible currency, less dependent on the dollar.

It’s a shrewd move, but not without costs: economists at Bloomberg Intelligence calculate that $40 billion leaves China for every 1 per cent decline of the renminbi. Currency in China is not unlike housing, fermented pu-erh tea (which can lose 85 per cent of its value in a bad year) or the Shanghai Stock Exchange Composite Index: all are prey to bouts of irrational exuberance and high levels of volatility. The index recently shot up from around 2000 to more than 5100 before plummeting back to 3500, all within a year. Every speculative surge disrupts the real economy; as elsewhere, the economic mandarins’ mandate is to stabilise exuberance.

Is flight out of the renminbi a sensible response to a surprisingly troubled economy? On the face of it, no: officially, China’s GDP is expanding at close to 7 per cent (or 5 per cent if you are a sceptic). After decades of dazzling growth, a soft landing, even a recession, ought not to be extraordinary. Are the prospects for the world’s second largest economy much worse than they are for the US? The latter has the benefit of the ‘dollar trap’: counterintuitively, the demand for dollars rises when the US economy is in crisis, or the government is approaching fiscal meltdown. America is a safe haven; China is not yet a place where the world’s wealthy would consider raising their children, as the Tianjin disaster has made evident. There’s still a way to go before global money flocks to the Middle Kingdom in good times and bad, and China enjoys the advantages of a renminbi trap.