Shyam Saran: Yuan depreciation and China's reforms

If the currency continues to slip against the US dollar, it might lead the Chinese govt to reintroduce very strict controls on cross-border transactions

The Chinese yuan is depreciating. During the year it has lost about six per cent of its value against the US dollar and expectations are that it may go down further. This trend comes at a time when the Chinese economy is slowing, foreign exchange reserves are down 25 per cent, from the high of $4 trillion just over a year ago, and fears of capital flight are becoming more pronounced. A number of measures have been introduced in the past week alone to reintroduce controls over capital outflow, though these have not been formally announced. For example, the People’s Bank of China will have to approve any remittances in excess of only $5 million, whereas the formal limit is $50 million. The bank has also made it known, through “advice” given to banks and corporate entities, that for the time being only 30 per cent of the value of shareholder’s equity can be remitted whereas there was no such limit earlier. Approval for imports of gold have also become more difficult to obtain. These measures go counter to the Chinese government’s express objective of internationalising the yuan as also against the norms that the country was expected to follow when its currency was made part of the basket of international currencies, which the International Monetary Fund uses to determine the rate of exchange for its Special Drawing Rights (SDRs). The inclusion of the yuan in the IMF basket in January this year was a matter of prestige for China. Several commentators expressed the view that this event would do for Chinese financial sector reforms what its entry into the World Trade Organisation in 2001 had done, accelerating market-oriented economic and trade reforms. That now appears a premature assessment as China once again demonstrates its unwillingness to let the market resolve the inevitable volatility that any freely convertible currency must be prepared for. This happened when Chinese stock markets went through a similar bout of volatility last year and the Chinese government’s response was to use an entire array of administrative measures to manage the fallout even though this was bound to have a negative impact on investor confidence and the credibility of the Chinese state.

It is difficult to predict what is likely to happen with the currency rate in the coming weeks. Some bankers expect the yuan rate against the US dollar to go down from the current 6.8 to over 7 by the end of the year. A rise in the US interest rates, as is expected, may push it down further. It is also not clear what a Donald Trump presidency will mean with regard to the very significant US-China trade volume, which is over $600 billion at the last count. 

Illustration by Ajay Mohanty

Mr Trump has repeated charges he made during the campaign that China manipulates its currency to artificially make its goods competitive. He has threatened to put an across the board tariff of 45 per cent on Chinese imports. Any practical moves in this direction will inevitably affect Chinese trade and economy and, therefore, the fate of its financial reforms. There is a danger of free fall of the Chinese yuan, which will almost certainly lead the Chinese government to reintroduce very strict controls on cross-border transactions even if this means reversing some of the key reforms that have been put in place incrementally but systematically over the past few years. Capital flight is the biggest worry for China these days. It will be recalled that during 2015, an estimated $1 trillion of funds appear to have left Chinese shores, some through formal channels but quite a bit through informal channels, such as over-invoicing of imports and under-invoicing of exports. An expectation of further devaluation of the yuan is already heightening the prospects of capital flight. Using the existing  foreign reserves to halt any precipitous decline in the value of the currency may deplete the reserves to risky levels in an uncertain global economic environment. Maintaining the reserves at safe levels will demand re-instatement of strict capital and currency controls, which will set back financial sector reforms possibly for several years.

The latest developments have already affected the offshore Renminbi (RMB) market. It has been reported that RMB deposits in Hong Kong, Singapore, ROK and Taiwan fell by 30 per cent in a month since August this year.

All this adds up to the vulnerabilities of the Chinese economy which have already heightened concerns about the world’s second largest economy. Chinese overall debt is now estimated at 280 per cent of its gross domestic product (GDP) and corporate debt alone is 170 per cent of GDP, according to S&P Global Ratings. To maintain a growth rate of 6.5 per cent per annum, which has been set by the Chinese leadership, the credit expansion will have to continue and is expected to reach 300 per cent of GDP by the end of 2017. There will be a debt-fuelled crisis if in the meantime confidence in the Chinese economy and in particular its currency turns negative.

The next several months are likely to be critical for China’s economic prospects and the risks of a “hard landing” have become several notches greater. It should be noted that this one-party state, which values regime survival, political and social stability above all else, will not hesitate to put reforms on the back burner if that is what is needed to deal with market volatility. But, it should also be acknowledged that in the three decades of economic reforms and accelerated growth, China has put in place vast physical infrastructure and an equally vast knowledge pool, which will enable it to pick up the pieces and resume reforms eventually. Until then, prepare for a bumpy ride because India will be affected by whatever happens to the world’s second largest economy.
 

The writer is a former Foreign Secretary.  He is currently Chairman RIS and Senior Fellow CPR.