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Manipulation redux

6 March 2015 By John Foley

China’s currency is entering a difficult third age. During the first one, which lasted over a decade, a weak yuan helped bring in export revenue. More recently, a strengthening currency helpfully sucked in capital. Now, with trade and confidence under pressure, China faces some hard choices over which it wants more. Premier Li Keqiang opened the annual parliament on March 5 by pledging more exchange rate flexibility, but also stability. The two aren’t necessarily compatible.

The yuan has weakened by 2.4 percent against the U.S. dollar since November. For exporters to the United States, that’s a helpful correction. But the dollar’s strength means that China’s currency has risen by 7.5 percent in the past six months on a trade-weighted basis, according to JPMorgan. On that measure, the euro is down 6.8 percent over the same period.

China is slowly becoming less dependent on exports for growth, but a too-strong currency could make the shift unacceptably painful. When it comes to investment, however, the sliding yuan is a bad sign. In recent years, relative strengthening has made China a magnet for investors attracted by the combination of relatively high interest rates and a currency that looked like a one-way bet. With the trajectory reversing, capital is starting to flow out. Though the People’s Bank can pump money into banks to replace what’s lost, there’s no guarantee it will flow to the same places.

Even if credit doesn’t dry up, a weaker yuan would increase the interest burden for companies that have borrowed in foreign currency. Real estate companies, which have tapped the offshore bond markets with abandon, would be exposed. China has amassed $260 billion of net, non-trade foreign currency debt since 2010, according to balance of payments data, and little of it is hedged.

China’s central bankers used to annoy trade partners by keeping the yuan artificially low. Now, they might have to do the opposite. However attractive it may seem to help exporters, accelerated capital flight and debt problems for companies would be worse. So even as China promises to give market forces greater sway over the yuan’s value, a return to meddling might be the least bad option.

 

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