Thoughts

June 21, 2024 | 15:17

Is the Risk of a Renminbi Devaluation Real?

Economist

Senior Economist and Director
Economics

Art joined the Bank of Montreal in 2014. His primary responsibility is analyzing global economic, financial and ... (Read more)

Erik Johnson

Senior Economist and Vice President
Economics

Erik conducts research on financial product market trends, emerging risks and macroeconomic trends for the Bank.... (Read more)

Art Woo

Senior Economist and Director
Economics

Art joined the Bank of Montreal in 2014. His primary responsibility is analyzing global economic, financial and ... (Read more)

Erik Johnson

Senior Economist and Vice President
Economics

Erik conducts research on financial product market trends, emerging risks and macroeconomic trends for the Bank.... (Read more)

Speculation that Beijing may—or should—consider a step-function devaluation of the renminbi has resurfaced. Although one cannot completely dismiss this possibility, we do not assign a high probability of a sudden, steep depreciation (say >5%). In our view, the costs of such a move could outweigh the benefits of a cheaper currency. Otherwise, it appears that China’s authorities are quite committed to its current ‘crawling peg’ exchange rate regime.

At present, the key rationale behind a devaluation is to give China’s struggling economy a Japanese yen-like boost to help stave off disinflationary/deflationary pressures. Note the yen’s move to nearly 160 from just over 100 over the past three years is considered the main driver behind the recent revival in consumer prices, which now sits above the Bank of Japan’s 2% inflation target. In contrast, Japanese inflation averaged just 0.5% in the 2012-21 period.

On the flip side, a large devaluation of the renminbi carries with it significant risks; namely, it could trigger strong capital outflows and financial instability. Though it’s true that Beijing has been consistently tightening capital controls since the sharp decline in foreign exchange reserves in the mid-2010s, the reality is that money still seems to find ways to escape—2023 was the first time in five years that corporate and household capital outflows exceeded inflows (by $68.7 billion). A surge in capital outflows (i.e., large-scale capital flight) could erode the banking sector’s deposit base and constrict domestic credit. This would place more pressure on China’s banking sector, where concerns over asset quality have moved into the spotlight given ongoing difficulties facing the residential property and local government financing vehicle sectors. Recall, the latter are the key off-budget entities that local governments rely on to build physical infrastructure.

Intentionally weakening the renminbi also carries other risks including further aggravating the country’s deteriorating relationship with the West. We suspect the U.S. Treasury would likely label Beijing a currency manipulator. Washington may also be emboldened to ratchet up tariffs on Chinese goods imports, especially in advance of the upcoming presidential election. It’s also not too difficult to imagine that a renminbi devaluation would have knock-on effects on exchange rates around the Asia-Pacific region, such as tit-for-tat depreciation to maintain export competitiveness.

It appears that China’s manufacturers are still not facing much difficulty exporting their goods around the world, especially given the recent turnaround in the global trade cycle. Merchandise exports in USD terms grew a stronger-than-expected 7.6% y/y in May. China’s exporters have already received a sizeable boost to trade competitiveness the past couple years from the real effective exchange rate having depreciated by nearly 15% since early 2022 (Chart 1). As interest rate differentials between the U.S. and China narrow, we forecast that the renminbi is likely to appreciate from nearly 7.3 now to closer to its fair value of around 6.8 to the U.S. dollar.

Key Takeaway: We consider rumours that China would consider leveraging its currency to help reflate its economy as more smoke than fire. The risks of such a bold move are likely too great for an economy that is otherwise coping with many other challenges.