China: Future of Yuan currency policy and Gulf implications
Despite holding the world’s largest dollar FX reserves, the Chinese have been faced by some sharp capital outflow
The war of words is heating up between China and Mr Trump, a few days before his formal inaugurations as President on Friday 20 January with the Chinese blasting Donald Trump for "playing with fire" after the US president-elect appeared to question the One China policy again. Mr Trump said in an interview on Friday that the policy was negotiable.
Under the longstanding policy, the US recognises Beijing as the only Chinese government, while maintaining an unofficial relationship with Taiwan. Mr Trump has questioned this arrangement, and in his latest remarks, in an interview with Fox News on Sunday, the president-elect suggested that the US should only continue to acknowledge China's position - that Taiwan is part of China - if Beijing agrees to make concessions.
"I fully understand the 'one China' policy, but I don't know why we have to be bound by a 'one China' policy unless we make a deal with China having to do with other things, including trade," Mr Trump said. As usual it would seem the Mr Trump sees it at a business level - that you should get what you pay for. And right now, Mr Trump believes the US has been doing all the paying and hasn't got enough in return and this centres around the value of the Chinese currency and Chinese government trade policies, but with the spat having far greater consequences on Gulf trade and world economies.
The Chinese Yuan, which threatened to break below the psychological 7.000 level against the dollar going into the New Year, instead reversed and surged over the first two trading days of 2017, pulling the dollar down against major global currencies along with it. But this was short-lived and the US dollar has been making strong gains against major world currencies on the premise that the new US President’s spending program and domestic economic revival would also lead to further US interest rate hikes.
Chinese officials believe that for 2017 the US and Chinese economies will continue to grow at divergent paces, and the US Dollar will continue to strengthen. In the big picture, it is clear that the number one and two major global economies – the US and China – will continue to grow at divergent rates through 2017 – and with that their respective monetary policies will diverge through the year as well. After devaluing for three consecutive years, Chinese officials expect the Yuan’s depreciation against the dollar through 2017 to be limited, and for this year to be the last year against which the currency weakens against the US. This undercuts Donald Trump’s assertion that the Chinese have been unfairly manipulating their currency against the dollar and keeping it undervalued to gain export market share, but the truth is far more deceptive as the Chinese are facing some domestic currency issues of their own.
This has led to the following four principles to guide foreign exchange (FX) and reserve management policy.
First, despite accusations of manipulation, that ensuring the relative stability of FX reserves is a higher priority than defending the Yuan exchange rate. In other words, the People’s Bank of China ( PBoC) should not unduly sacrifice FX reserves to stabilize the exchange rate; second, the PBoC should nevertheless continue to try and maintain the pace of depreciation against the dollar at a “slight” level vis a vis other major currency depreciations against the dollar, meaning the Yuan should not weaken much more against the dollar than other major currencies do; third, the PBoC should continue reducing dollar assets as a portion of the country’s FX reserves, translating primarily into a continued sale and gradual reduction in the size of China’s US treasury holdings, and fourth, that FX reserves should in turn be invested more heavily in countries along the “One Belt, One Road” Initiative Europe, Russia, South Asia, Southeast Asia, and parts of Middle East like the Gulf countries, to the extent feasible, which is good news for countries like Saudi Arabia with its Vision 2030 placing the country as a central location for trade and manufacturing.
Despite holding the world’s largest dollar FX reserves, the Chinese have been faced by some sharp capital outflow and FX drawdown pressures, and Beijing has imposed restrictions on the ability of individuals to invest their annual $50,000 FX quota overseas, as well as a huge squeeze in funding interest rates for holders of Yuan short positions – with Hong Kong overnight Yuan rates at one point hitting a high of 80%. Chinese officials believe the bulk of the recent pressure on Yuan devaluation has not come from foreign speculators, but from Chinese citizens. China’s domestic capital, mainly capital from private enterprise, upper, and middle class individuals, has flown through various channels into US dollars.
Despite holding the world’s largest dollar FX reserves, the Chinese have been faced by some sharp capital outflowDr. Mohamed A. Ramady
In a very quiet manner, there has been a degree of unspoken US cooperation with the Chinese over their currencies and especially US interest rate policies. The US Federal Reserve has held back in 2016 from raising dollar interest rates, not because it feared the effect on the US economy but in assisting China from further capital outflows and FX reserve drawdown if dollar interest rates hiked and made the dollar more attractive. Maintaining a healthy Chinese economy that grew at a steady pace to sustain other world economies, and not creating another global contagion on Asian and Latin American countries seemed to have been an unspoken Fed policy agenda, vividly demonstrated when the Chinese economy showed faltering signs at the beginning of 2016. However, with Trump’s domestic economic consideration in the fore, the US Federal Reserve might change policy direction and raise US interests rates in 2017, putting even more pressure for a devalued Yuan, rather than the opposite.
2018, for what it’s worth, is expected to bring in a year of modest Yuan appreciation. But for now, China’s economy is still slowing, with growth trend still seen to be L-shaped at between a 6.5% to 7% growth level, while the US is picking up pace. Officials thus fully expect dollar strength to continue, while Beijing continues to focus on potential contractionary policies broadly aimed at preventing risks, curbing bubbles, and de-leveraging the financial system. For the Gulf, with its ever expanding trade and energy relations with China, any dislocation in the Chinese-US currency relationship could lead to higher regional imported inflation, interest rate and currency speculative pressure. The coming months will indeed be interesting times, as the famous Chinese saying goes.
Dr. Mohamed Ramady is an energy economist and geopolitical expert on the GCC and former Professor at King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia.