A sharp drop in the value of the yuan appears imminent, even though its international prestige has been heightened with a decision by the International Monetary Fund to include the Chinese currency in the basket of currencies constituting the special drawing rights. A dreadful slump affecting China’s export-oriented industries has accelerated selling of the yuan on the exchange market while doubts have been cast on Beijing’s ability to shore up the currency.
A rapid fall in the yuan’s value could further exacerbate the Chinese people’s purchasing power and deal a serious blow to a global economy already being shaken by slowdowns in many emerging economies.
Last month, money dealers throughout the world started feeling uneasy as the People’s Bank of China, over the course of several days, lowered the yuan’s standard exchange rate against the dollar to the lowest level in 4½ years.
The Chinese central bank announces an official standard rate for the yuan on the morning of each business day. Its aim used to be preventing a sharp increase in the value of the yuan due to the expansion of China’s trade surplus. It reflected the central bank’s will to intervene in the market if the actual rate moved toward a higher yuan. But the situation started to change last year.
A trend of the actual rate being lower than the standard rate has become strong. Beijing’s sudden lowering of the standard rate in August 2015 is believed to have been aimed at underpinning export-oriented industries as well as eliminating a gap of about 3 percent between the actual and standard rates. It is safe to say that the yuan’s rise since the beginning of this century has ended.
The question arises as to why the currency is becoming weaker despite the mounting trade surplus that China has been accumulating — from $154.9 billion in 2011 to $383 billion in 2014 and $485.7 billion in the first 10 months of 2015. The answer is found in “structural reform on the supply side,” a phrase which has become a catchword among political leaders, central and local bureaucrats, and economists since it was used by President Xi Jinping last November at a key economic meeting in Beijing.
China is beset with huge excess production capacity in most major industrial segments. For example, while it has the capacity to produce 1.15 billion tons of crude steel per year, combined demand at home and abroad is only 800 million tons. Similarly, its capacity to build more than 35 million motor vehicles a year far surpasses demand, which is only 25 million units. Vigorous capital investment in the manufacturing sector during the years of high economic growth fanned by abundant money supplied by banks has led to astronomical amounts of surplus production facilities.
Such overcapacity has led to cutthroat competition, deterioration of corporate profits and bankruptcies among manufacturers as well as a surge of bad bank loans. The situation made it clear that the root problem of the Chinese economy lay in the supply side. The government initially tried to cope with this problem by stimulating demand, exemplified by its decision in 2008 in the aftermath of the Lehman Brothers shock to spend 4 trillion yuan (about ¥57 trillion at the exchange rate at the time) to build high-speed railways, airports, industrial parks and the like.
After it became apparent that measures on the demand side could no longer be a solution, the only way left to overcome the crisis is to implement reform on the supply side. In 2014, this new approach was given the name “the new normal,” which has now been changed to “structural reform on the supply side.”
Logical policies along this line should be to scrap excess production capacity, weed out unhealthy businesses and combine enterprises. But such corporate restructuring would create new problems, such as shrinking consumer demand, growing unemployment and stalling of local economies, which in turn could send the Chinese economy straight into a hard landing.
The only rational way out of this path is to boost exports. Indeed, steel makers, shipbuilders, and manufacturers of home electric appliances, smartphones and the like have stepped up their endeavors to sell abroad. But the trouble is that most of these export-oriented firms are losing money. Shanghai Baosteel, Wuhan Iron & Steel and Shagang Group, all ranking among the world’s top steel makers, have fallen in the red. Even though China’s steel exports last year reached 115 million tons, or twice the level of two years earlier, the steel industry as a whole posted a loss of 100 billion yuan (about ¥1.9 trillion).
The chief culprit is a high exchange rate of the yuan. Even though its relationship with the dollar has not changed much during the past two years, its value vis-a-vis the weighted average value of the currencies of countries importing Chinese goods went up by 12 percent during the past 18 months, according to the Westpac Banking Corp. of Australia.
The Chinese leadership has become increasingly aware that promoting supply-side structural reform would require devaluation of the yuan. And there are means available to devalue the currency against the dollar by 10 to 20 percent rather quickly. All it takes is to stop buying the dollar in the market — a practice designed to prop up the value of the yuan.
But the leaders in Beijing are reluctant to take such a step since they fear it might cause a “free fall” of the yuan and ignite a scramble among Asian countries and newly emerging economies to devalue their currencies, which would hit Chinese exports’ competitiveness and increase import prices.
A big factor behind the continuing fall of the yuan is capital flight. Shrewd Chinese investors have quietly started to shift money into the real estate and stock markets in countries like the United States, Canada and Japan. The flight of Chinese money is likely to gain momentum with clearer signs of further weakening of the yuan. This could ruin the domestic real estate market, which barely has underpinned the Chinese economy, and adversely impact the stock market, where the government is endeavoring to keep share prices up. These developments would leave banks stuck with a large amount of bad loans they can’t handle.
The weakening in China’s purchasing power that would result from the currency devaluation would devastate not only those Japanese benefiting from the “explosive buying binges” by Chinese tourists but also a wide range of industrial segments in the global market — from iron ore, coal, construction machinery and rolling stock to shipping — plus real estate and stock markets in big cities around the world.
The gap between the official and actual exchange rates of the yuan was eliminated in 1994 when the government drastically lowered the currency’s value. This served to strengthen the competitiveness of Chinese exports and made China the “factory of the world.”
Its expanding trade surplus and mounting pressure from abroad for a higher yuan led China in July 2005 to raise the value of its currency and shift to a floating exchange rate system. But the yuan-dollar ratio in 2014 was close to the official ratio before the 1994 devaluation. In other words, the yuan’s value against the dollar today has returned to what it was 20 years ago.
Beijing is now trying to repeat the scenario of 1994 through the devaluation of the yuan, hoping that exports will become more competitive and that the country will regain its status as the world’s factory.
But, as indicated by the inclusion of the yuan in the special drawing rights scheme of the IMF, the Chinese currency now plays a far greater role in the global market than in the past. The world can no longer tolerate China manipulating the value of its currency solely for its own benefit.
The problem, however, is that the Chinese leadership is not fully aware of the responsibilities placed on the yuan. If anything goes wrong with the devaluation process, the entire global economy could plunge into a recession.
This is an abridged translation of an article from the January issue of Sentaku, a monthly magazine covering political, social and economic scenes.