The renminbi (RMB) has tumbled in recent months. Since the start of June, it has lost more than 5% against the greenback.
Comparing this time with the situation in 2015-2016 (Figure 1), the Mainland’s foreign reserves remain largely stable, implying that the People’s Bank of China (PBoC) so far has not made heavy use of its reserves to support the RMB as it did previously. On Monday, RMB’s midpoint weakened to 6.8131 against the U.S. dollar, hitting a 13-month low.
Beijing is more relaxed about the RMB’s weakening this time, for a number of reasons. With a cheaper RMB, Chinese exports to the United States have become less expensive and thus the effects of tariffs imposed by the U.S. are partially offset. Also, the lesson was learnt in 2015 that defending the currency by quickly depleting the reserves would only shake investor confidence and result in more capital outflows.
That being said, the PBoC’s tolerance for now does not mean it will allow the currency to slip freely or more vigorously. Some might believe that an even steeper RMB decline is a good tactical move as it will boost Chinese exports and hence the economy in the wake of slower economic growth in the second quarter. Real GDP expanded by 6.7% year-on-year in the second quarter, its slowest pace since 2016.
But a further depreciation of the RMB will have side effects, and it might trigger economic and financial instability if it goes too far.
First, it will pose problems for companies exposed to dollar-denominated debt. Since the global financial crisis, Mainland China’s total foreign debt has almost quadrupled, with short term debts growing faster than long term ones (Figure 2). The RMB depreciation will definitely add pressures to companies (including exporters) to service and repay their U.S. dollar debt.
Second, while the Mainland has been reducing its dependence on imported components for production and concentrating more on domestic production, the imported content of exported goods remains as much as 30% (Figure 3). Therefore, the benefits of RMB depreciation to the export sector are constrained as the cost of imported components will also increase.
Third, the risk of an even steeper depreciation is that it would be interpreted as a signal to Washington -- and to other Asian countries -- that Beijing might want to stop one war by starting another on a different front. This could turn into a vicious cycle and jeopardise the process of RMB internationalization. In fact, Hong Kong, which has the largest RMB liquidity pool outside Mainland China, saw its RMB deposits drain rapidly during 2015-16 when the currency weakened (Figure 4).
To sum up, the real world is more complicated than textbook theories. While a weaker RMB could boost export competitiveness to a certain extent, if it goes too far, it might actually hurt the economy as a whole. Moreover, it can lead to a dangerous situation if the market has a one-sided bet on RMB depreciation.
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