FX International Payments
By Frances Coppola
One country often in the spotlight when the U.S. dollar exchange rate rises is China. China’s currency, the yuan (CNY), has been on something of a roller-coaster ride since the People’s Bank of China (PBOC) devalued it in August 2015. Its dollar exchange rate rose considerably in 2017-18, reaching 6.28 to the dollar in April 2018.1 But since then, its dollar exchange rate has gradually fallen back to approximately 6.8 to the dollar, roughly the same as a decade ago.2
CNY doesn’t float freely against the U.S. dollar (USD). However, the “offshore” yuan (CNH), which is traded through financial centers outside mainland China such as Hong Kong, Singapore and London,3 does float against USD. The PBOC uses the CNH’s market value against a trade-weighted basket of 13 currencies, of which USD is the most dominant, as a reference point when setting CNY’s daily exchange rate.
This does not mean CNY and CNH exchange rates are always the same. Sometimes, the PBOC sets a different rate for CNY. The gap between CNH and CNY can be taken as an indicator of the extent to which the PBOC is responding to market rates in setting the CNY exchange rate. In the last two years, CNY has closely tracked CNH, with deviations occurring mainly at times of high volatility in the CNH exchange rate.4 Thus, it is likely that CNY’s dollar exchange rate now mainly does reflect market conditions.
Although recent data suggests CNY’s exchange rate is mainly market-determined, China does have a history of intervening to move its exchange rate in a desired direction. This is not necessarily downward. In 2016, the PBOC was setting CNY at a higher rate than CNH to ward off capital flight.5 In October 2018, the U.S. Treasury commented that the PBOC was no longer actively intervening to raise the CNY’s dollar exchange rate, as it had in the “recent past.”6
However, the U.S. Treasury expressed concern about the weakening CNY dollar exchange rate, because it was likely to widen China’s current account surplus with the U.S. Although China’s overall current account surplus has declined considerably and now stands at about 0.5 percent of GDP, its current account surplus with the U.S. is still large and persistent, at $390 billion in 2017-18. The U.S. Treasury concluded that China did not appear to be actively depressing the CNY’s dollar exchange rate but said it would “monitor” the situation, especially in regard to the current account balance.7
Meanwhile, the International Monetary Fund (IMF) believes the CNY’s falling dollar exchange rate mainly is due to the strong dollar. At a press conference in October 2018, the IMF’s Managing Director, Christine Lagarde, observed that CNY had not depreciated as much against other currencies as it had against the USD, and commented, “If you compare the position of the [yuan] relative to the dollar, it is one particular story, which has also a lot to do with the strength of the dollar.”8 The staff report from IMF’s Article IV consultation with China in July 2018 notes that the CNY is “broadly in line with fundamentals.”9
Brad Setser, a senior fellow for international economics at the Council on Foreign Relations, examined the flow of FX reserves in September 2018. Typically, when a central bank is trying to depress the currency exchange rate, it sells its own currency and buys foreign-denominated assets. Thus, FX reserves should rise if the currency exchange rate is lower than the market rate. Setser’s analysis showed that net FX reserves in China remained broadly unchanged. He too concluded that the PBOC was simply allowing the CNY to drift downward in response to the strong dollar.10
There are also economic reasons for a weakening CNY exchange rate. China’s economic growth is slowing, reflecting weaker industrial output and consumption.11 A poorer outlook for the economy tends to lower the exchange rate.
There is another reason, too, why the CNY exchange rate might fall. China’s strong growth since the financial crisis of 2008 has been driven by a large credit boom. The IMF projects that China’s official government deficit will rise to 4.1 percent of GDP in 2018 and official government debt to 35 percent of GDP. However, much of China’s government borrowing is carried off its balance sheet: the IMF’s calculations show local authorities and other off-balance sheet items raising the deficit to over 10 percent and debt to 90 percent of GDP by 2023.12 Corporations, too, are highly indebted. Non-financial corporate debt is around 130 percent of GDP.13 China is now tightening credit conditions, but the IMF expressed concern that credit growth is still “excessive” and there is a risk of financial crisis.14 Investor concerns about the sustainability of China’s debt tend to weigh on the CNY exchange rate.
The CNY’s weakening dollar exchange rate seems to be mostly a strong dollar story. However, there also are more fundamental reasons for the yuan’s weakness. The Chinese economy is slowing down, but both government and corporate debt are high. There is growing international concern about the possibility of debt crisis and recession.15 Although the PBOC may continue to smooth out short-term volatility in the CNY exchange rate, it is possible that the CNY will weaken further.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. CNYUSD, FRED Economic Data; https://fred.stlouisfed.org/series/DEXCHUS
3. “CNH vs CNY: Differences between the two Yuan,” DailyFX; https://www.dailyfx.com/forex/fundamental/article/special_report/2018/09/12/cnh-vs-cny-differences-between-the-two-yuan-.html
6. “Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States,” U.S. Treasury; https://home.treasury.gov/system/files/206/2018-10-17-%28Fall-2018-FX%20Report%29.pdf
8. “Transcript of IMF Managing Director Christine Lagarde’s Opening Press Conference, 2018 Annual Meetings, Bali, Indonesia,” International Monetary Fund; https://www.imf.org/en/News/Articles/2018/10/11/tr111018-transcript-of-managing-director-christine-lagarde-opening-press-conference-2018-ams-baliind
9. “People’s Republic of China: 2018 Article IV Consultation – Press Release, Staff Report, Staff Statement and Statement by the Executive Director for the People’s Republic of China,” International Monetary Fund; https://www.imf.org/en/Publications/CR/Issues/2018/07/25/Peoples-Republic-of-China-2018-Article-IV-Consultation-Press-Release-Staff-Report-Staff-46121
10. “China Bought Foreign Exchange In September (Just Not Very Much),” Council on Foreign Relations; https://www.cfr.org/blog/china-bought-foreign-exchange-september-just-not-very-much
11. “China Posts Weakest Growth In A Decade, Scrambles To Soothe Investors,” Wall Street Journal; https://www.wsj.com/articles/china-growth-slows-to-6-5-finance-officials-try-to-soothe-worried-investors-1539917129
12. “People’s Republic of China: 2018 Article IV Consultation – Press Release, Staff Report, Staff Statement and Statement by the Executive Director for the People’s Republic of China,” International Monetary Fund; https://www.imf.org/en/Publications/CR/Issues/2018/07/25/Peoples-Republic-of-China-2018-Article-IV-Consultation-Press-Release-Staff-Report-Staff-46121
14. “Credit Booms – Is China Different?” International Monetary Fund; https://www.imf.org/en/Publications/WP/Issues/2018/01/05/Credit-Booms-Is-China-Different-45537
15. “China’s debt: time to rein in the lending boom,” Financial Times; https://www.ft.com/content/0c7ecae2-8cfb-11e8-bb8f-a6a2f7bca546