As the yen’s downward spiral continues, could the yuan be forced into a collateral devaluation?
As the Japanese yen dives toward 150 to the dollar, investors are concerned less about events in Tokyo than in Beijing.
Since 2016, Chinese President Xi Jinping has championed a “strong yuan” policy. That was the year the yuan scored a place in the International Monetary Fund’s special drawing rights basket. It put the yuan in league with the dollar, euro, yen and British pound, elevating China into the reserve-currency orbit.
Even as former US President Donald Trump bashed China’s exchange rate, accusing Beijing of “killing” American livelihoods, the yuan ratcheted higher. The trajectory served Xi’s efforts to get China added to global stock indexes like MSCI and bond benchmarks like FTSE Russell. Despite slowing growth in 2021, the yuan held its ground in global markets.
Now, the yen’s plunge is putting Xi’s strong yuan stance to the test.
Chatter in Beijing and in global markets has it that pressure is mounting for a change in Chinese currency strategy, and that it is particularly pressing as mainland growth slows.
Former Goldman Sachs economist Jim O’Neill goes so far as to worry that China might respond in ways that destabilize Asia along the lines of the chaos of the late 1990s.
“China would not want this devaluing of currencies to threaten their economy,” O’Neill told Bloomberg recently. “If the yen keeps weakening China will see this as unfair competitive advantage – so the parallels to the Asian financial crisis are perfectly obvious.”
O’Neill notes that, “if we see the Bank of Japan sticking to yield curve control and we see bond yields continuing to rise in the US, this kind of momentum and the fallout could create real problems in Beijing” as the odds that it will meet this year’s 5.5% growth target dwindle.
Yet such views may ignore Xi’s determination to let the yuan rise.
Case against devaluation
Arguably, increasing the yuan’s role in global trade and finance is Xi’s top economic legacy to date. Xi understood that transforming China into a services-and-innovation powerhouse would require a rising currency. The less the manufactured exports and smokestack industries drive growth, the less need China has for a weak yuan.
Also, pulling in trillions of dollars of foreign investment is easier when CEOs from New York to London to Tokyo trust China’s currency.
Surging inflation also supports the argument for a stronger exchange rate.
So far, China’s price environment has remained largely tame. The consumer price index rose just 2.1% in May from a year earlier, a fraction of the 8.6% surge in the US last month.
Factory-gate inflation actually cooled in May, recording its weakest increase in the last 14 months. China’s producer price index rose just 6.4% year-on-year, down from an 8.0% increase in April.
The data series “will continue on its downward trajectory throughout the rest of the year,” says Sheana Yue at Capital Economics.
A significant drop in the yuan exchange rate could reverse this virtuous inflation dynamic.
Across the Pacific, there are different problems – notably, the growing alarm that the Federal Reserve has lost all control over inflation.
As economist Mohamed El-Erian at Allianz puts it: “I think you’ve got to be very modest about what we know about this inflation process. And I fear that it’s still going to get worse, we may well get to 9% at this rate.”
China confronts a different problem. Slowing mainland demand has the People’s Bank of China mulling “further policy rate cuts before long,” Yue says.
Last month, PBOC Governor Yi Gang cutby 15 basis points the five-year loan prime rate used to price home mortgages. The PBOC is cajoling major commercial banks to boost credit support.
In recent weeks, Premier Li Keqiang has warned that letting economic growth contract in the second quarter would be a major blow to business and household confidence – and, by extension, a blow to getting as close to 5.5% growth as possible.
The fallout from China’s draconian “zero Covid” lockdowns in Shanghai and other major metropolises continues to slam national growth. Economist Iris Pang at ING Bank thinks Shanghai’s gross domestic product will shrink 6% this month. That could mean a 2% GDP increase for the national economy.
Economist Andrew Fennell at Fitch Ratings is more optimistic. He expects China will grow 3.7% on the assumption that pandemic-related restrictions will be phased out.
“There’s considerable uncertainty over when the authorities will pivot away from their current ‘dynamic zero Covid’ policy strategy,” Fennell says. “In the absence of official guidance, Fitch assumes this process will not begin until at least 2023, and proceed at a tentative pace.”
There are risks, though, that side effects may cause headaches going forward. With policymakers vowing to stabilize near-term economic momentum, Fennell expects credit growth to accelerate over the coming months. “This,” he says, “will lead to a double-digit rise in China’s economy-wide leverage ratio this year, after it fell modestly to about 264% of GDP in 2021.”
At the same time, Fennell says, the yuan has been allowed to depreciate versus the US dollar since early April. Fitch, Fennell says, “views these trends as largely influenced by the US dollar’s trade-weighted appreciation and market concerns over China’s growth slowdown.
The bigger question, though, is whether the Communist Party tries to make a weaker yuan official policy. That, of course, might run afoul of Xi’s inner circle, which may be reluctant to squander these last six years of building trust in the currency as a store of value.
Tokyo’s plunging prospects
An ongoing yen slide could prove particularly problematic for Beijing’s 2022. Episodes of yen weakness tend to shake up global markets. In the late 1990s and early 2000s and during the 2008-2009 global crisis, sharp yen moves rocked global markets.
The reason is that many global investors borrow cheaply in yen and then reinvest it in higher-yielding assets. When the yen suddenly zigs and investors need the zag, chaos often ensues.
Now “the yen is on track towards a parabolic move, with global and Japanese macro players set to get increasingly aggressive in betting on an overshoot towards 150-160” to the dollar, says Jesper Koll, a senior advisor to investment group Wisdom Tree.
The question, Koll adds, is what if China were to complain about excessive yen weakness? “They did so the last time the yen weakened past 135-140 in mid-1998,” Koll observes.
One thing has changed: the US might be less receptive to Chinese complaints this time around. “In 1998, America was focused on getting China to join the World Trade Organization and was happy to try and be helpful,” Koll says. “Today, America regards China as its principal competitor.”
There’s an argument that the yen might bottom out soon, says strategist John Vail at Nikko Asset Management, citing potentially worsening matters in Ukraine or China. That could lead US Treasury 10-year yields to “also calm down and, in turn, the yen’s weakness versus the US dollar should be curtailed,” Vail says.
Political pressure to tame the yen is rising in Tokyo. A survey by Tokyo Shoko Research finds nearly half of Japanese companies believe the weak yen is bad for business. This marks a real sea change in Japan Inc’s views on exchange rates.
Now, respondents say the yen is inflating raw material costs, damaging retailers, spooking households and creating headwinds for politicians who are contesting parliamentary elections next month.
But odds are, the yen’s drop will intensify as the BOJ keeps its foot on the monetary accelerator and the Fed slams on the brakes.
“The ongoing backdrop to the yen’s fall is the growing gap between long-term interest rates in Japan and the United States,” says Takahide Kinouchi at Nomura Research Institute. As global energy prices rise, “expectations are growing stronger that aggressive US monetary tightening will continue, for the time being, causing US yields to rise further.”
There’s an argument that the BOJ should consider intervening in markets to buy yen. But the situation now may be out of Tokyo’s hands.
“Of course, they could have intervened but it’s really a waste of time and resources,” says strategist Bipan Rai at the Canadian Imperial Bank of Commerce.
Only a sustained bout of coordinated and aggressive intervention by the BOJ, the Fed and the European Central Bank might halt the yen’s collapse.
In the meantime, all eyes are on how China might respond.
Asia Times