Luc Vallée is chief strategist at Laurentian Bank Securities.
Since May of 2014, the U.S. dollar has gained more than 25 per cent against a basket of currencies with one major exception: the Chinese yuan. Tightly pegged to the dollar until recently, it has been quite stable but is now under siege as economic woes are forcing China's central bank, the People's Bank of China (PBOC), to lower interest rates while the U.S. Federal Reserve leans toward tightening.
As long as the yuan was pegged to the dollar, it was relatively straightforward for investors to borrow cheap U.S.-dollar funds and pocket the "carry" on investments in China. Such trades were attractive when China was growing fast and the peg held. But now that China is decelerating and the peg is challenged, investors and policy makers are suddenly worried.
This situation has the Federal Open Market Committee, meeting this week to announce its next course of action, in a real bind. On the one hand, the U.S. economy is very close to full employment. On the other hand, considerations that would have been ancillary in the past – notably the stability of the yuan – are increasingly relevant to the global growth outlook, worldwide inflation expectations, and the stability of the global financial system. The Fed can no longer ignore them. Here's why.
The strengthening dollar is the standard market reaction to current diverging economic policies. Yet, too much appreciation too rapidly could be destabilizing. For one, it is putting pressure on China's central bank to drop its peg in an abrupt and disorderly manner in order to remain competitive – after all, in the past two years, because of its peg to the dollar, the yuan appreciated against most of the currencies of China's trading partners. It's the potential for a disruptive unpegging of the yuan to the U.S. dollar that's ultimately behind the recent market jitters. And these apprehensions are likely to persist if U.S. interest rates rise too quickly and put more upward pressure on the dollar, which, in turn, could destabilize the yuan.
In today's highly leveraged world, a significant yuan devaluation could corner unprepared Chinese investors indebted in U.S. dollars. China's financial system remains opaque and such risk exposure can only be measured from questionable statistics with a significant delay. However, some put the dollar-denominated debt taken by Chinese companies since 2008 at about $1-trillion (U.S.). A weaker yuan would increase the value of that debt, thereby increasing the likelihood that these investors default in a destabilizing way.
Because of the prospect of a yuan devaluation, investors also massively want out of China, forcing the PBOC to intervene further to defend the currency. As a result, foreign-exchange reserves fell by $513-billion in 2015, the first annual drop since 1992. Had it not been for China's $595-billion trade surplus, it would have been worse. Outflows accelerated after the PBOC attempted to let the yuan float in August before rapidly changing course: Increasingly worried investors have taken about $1-trillion out of China in the past six months. In December alone, reserves fell by $108-billion, the largest such drop in 12 years.
In spite of the PBOC's extensive efforts to stabilize the yuan, investors still expect it to depreciate. The recent inclusion of the yuan in the International Monetary Fund's Special Drawing Rights basket is also adding to the devaluation pressures as it commits the PBOC to letting the yuan float within a short time frame. Yet, these factors should not sway the PBOC to readily abandon its grip on the yuan.
First, allowing the yuan to find its bottom and dumping China's domestic growth problems on the rest of the world is neither practical nor desirable. China's trading partners, such as South Korea and Taiwan, are already suffering from disinflation and overcapacity and would be immediately affected by a yuan devaluation, while the benefits to the Chinese economy would be uncertain and take a long time to materialize.
Second, a significant devaluation would risk triggering a wave of devaluation in Asia that would export deflation globally. The temptation by China's trading partners to devalue could also give rise to further rounds of competitive devaluations. In this situation, the carry trades mentioned above would suffer even larger losses and potentially also threaten the financial system of other countries.
So what is the PBOC to do? Gradually bringing down the yuan's value would allow carry trades to be orderly undone and limit the odds of a financial crisis and the likelihood of a currency war. Such a gradual slide will be not easy to engineer, however. As long as the yuan is maintained artificially, investors will be tempted to bet against it. This will prolong the battle at great costs to the PBOC, which will use its reserves to defend the currency with the knowledge that the end game will be a weaker currency. But time has its advantage, if resources are used appropriately to avert a crisis – the PBOC has massive reserves of $3.3-trillion built for this precise purpose, and the country is still running a large trade surplus.
Moreover, there are already encouraging signs that the Chinese economy is stabilizing. Land sales are up and car sales and production are booming after being down for most of the past year. Chinese companies have also increased investment as healthy borrowing on the corporate bond market suggests. Lastly, observers expect the government to readily adopt further measures to stimulate growth.
What about the Fed? When its rate-setting committee meets this week, it should stick to its plan, but tread carefully. The disruption a sharp dollar appreciation may trigger could have unexpected and undesirable consequences. Such risks call for a more gradual approach to the rebalancing of global currencies and thus a more moderate path of rate increases.
Some markets are already ahead of the Fed. Only two rate hikes are now being priced in for 2016 and the greenback hasn't gained much ground against the yen and the euro recently. However, stock markets, more aligned with the real economy, are still expecting the worse. Some credible acknowledgment of the situation by the Fed, while guiding investors toward slower rate hikes, would help restore confidence and growth.