The People’s Bank of China has historically exercised great control over domestic Renminbi valuation, but the traditional tools used for currency management are beginning to come under stress.
This monetary strain will be exacerbated by activities in the United States including an expected rise in interest rates and an aggressive stance against China by the incoming Trump administration. These factors pose significant challenges to China’s long-term growth targets even as Beijing carefully manages the Yuan’s devaluation.
China has historically been dependent upon a handful of levers for currency management, and Beijing’s favored lever of control fluctuates as time passes. One of these tools, China’s foreign exchange reserves, has realized rapid depletion from significant use in recent years. In December, reserves fell by $41 billion to $3.01 trillion. While still at a safe level, it is unlikely that Beijing can dip well below the current reserve without realizing increased currency and market volatility. The selling of its reserve of US dollars has been the tool of choice to slow the rate of Yuan depreciation, but further depletion of China’s foreign exchange reserves will have to slow in 2017.
A second lever to stabilize Renminbi value is China’s use of currency controls. These controls set strict limits on one’s ability to move Yuan out of China into an alternate currency such as the Dollar. With concerns mounting about Beijing’s continued ability to effectively manage currency value coupled with stronger currency value outside China, Yuan has flooded out of the country. In 2016 alone, China realized at least $650 billion dollars of capital outflows with some estimations as high as $1 trillion.
China’s domestic economic choices have also served to drive capital elsewhere. In addition to exports, the backbone of Chinese growth has been domestic investment enabled by liquidity creation and mounting debt. While this strategy has enabled Beijing to meet its stated annual growth targets, it has also created an unstable market environment with manufacturing overcapacity, and the continued infusion of liquidity does not seem to be slowing. New Chinese bank loans rose by more than 20% to 1.04 trillion Yuan in December from the previous month further exacerbating concerns over debt.
To help curtail this hemorrhaging of capital abroad, Beijing further tightened capital controls in December. These new measures to prevent capital flight will likely not be the last, but while the trend will likely slow in 2017, there is little Beijing can do to significantly stem the tide.
These difficulties faced by Beijing in slowing the devaluation of the Yuan will likely be exacerbated by both US trade and monetary policy in 2017. As the US economic outlook continues to improve, the Federal Reserve will continue to tighten monetary policy with several additional interest rate increases throughout 2017.
These higher rates will further encourage capital flight from China in seek of higher yields and strain recently tightened controls. In contrast, the relative depreciation of the Renminbi will force Chinese firms to increase domestic borrowing to avoid higher real debts. This will place further stress on Chinese banks already exposed to rising debt levels and corresponding delinquency and default rates.
In addition to external risk from US monetary policy, China will likely also face an incoming Presidential administration advocating for a rise in Sino-US trade barriers and a public labeling of China as a currency manipulator. These trans-Pacific risks, but particularly the threat of a trade war, could roil Chinese markets and threaten the country’s export-driven economic growth.
China is uniquely conscious of the nearing limits of its currency management. Without significant economic policy change, the impact of Beijing’s loosening grip on its ability to prop up the Renminbi will likely be felt within the next two years. Changes required to alter this course would include moving towards the free-float of the currency, addressing the mounting level of bad debt, an alleviation of domestic asset bubbles, and a stabilization of foreign exchange reserve levels.
It is, however, unlikely that these issues will be addressed in the coming year. Required economic policy shifts would likely cause Beijing to fall short of annual GDP growth targets, a politically perilous outcome prior to the 19th National Communist Party Conference in the fall. With Party leadership subject to change, and current President Xi Jinping likely to be reelected, it is unlikely Chinese leadership would wish to unilaterally rock the economic boat in the near term.
Should there be a strong US challenge regarding trade or regional security, the elections would likely drive Chinese leadership to bold action as a demonstration of political strength. Beijing would certainly like to avoid a trade war and would likely make overtures to protect access to the US export market. If, however, tariffs were to be imposed by a Trump administration, any negative impact to China’s export market would likely be compensated by increased domestic investment to ensure net growth.