Affinity Policy Comment 29 april 2024

Will China Devalue?

There is quiet yet mounting speculation that China will need to take an extreme and highly controversial measure to support its moribund economy — devalue the CNY in a big-bang move.

China has stockpiled some commodities, which has led to speculation that it plans to devalue its currency. At the same time, the Chinese economy is still struggling more than a year after coming out of Covid lockdowns and giving a boost to exports through a devaluation could support the manufacturing sector. A weaker currency could also alleviate the deflationary pressures. For a CNY decline to be characterised as devaluation, it would in our view imply that China stops its actions to slow the depreciation and a rapid decline of the CNY to take place within a short period by at least 5-10 per cent versus the USD. Hence a move to around 7.80 from the current levels of 7.25.

These seem to be good reasons why China might want a weaker currency. Nevertheless, there are several arguments pointing towards China refraining from a devaluation, the first being that China has a strong preference for stability and control. This was stressed as recently as during the National People’s Congress in March this year, where the Work Report said that “stability is of overall importance, as it is the basis for everything we do”. At the Central Financial Work Conference in September 2023, China said that “the management of foreign exchange markets should be strengthened, and the RMB exchange rate should be kept generally stable at a reasonable and balanced level.”

A devaluation would entail a high risk of instability and loss of control. The 2015-2016 currency turmoil triggered capital outflows and sharp equity declines when investors saw the PBOC’s 2 per cent adjustment of the USD/CNY fixing as a sign that China was going to make a bigger devaluation - which was in fact done to meet an IMF requirement for entry into the SDR, which said that the fixing should be close to the spot rate. The latter was trading 2 per cent weaker than the fixing prior to the adjustment.

Furthermore, China intervenes to slow CNY depreciation, not increase it. Since the autumn last year, China has taken active steps to slow any further depreciation of the CNY versus the USD, most visible in the broadly stable currency fixing since August 2023. China has also refrained from cutting policy rates significantly to avoid too much divergence with US monetary policy that could increase depreciation pressure. Both words and actions reveal a preference for currency stability rather than a sharp weakening.

A devaluation would also undermine efforts to shore up foreign investor confidence. China took several measures in February to try and turn the negative equity sentiment around this year and has struggled to improve foreign investor sentiment. Since the measures in February, the battered stock market has recovered somewhat with a gain of around 20 per cent in offshore stocks as increasing numbers of foreign investors have returned. A devaluation would undermine investors’ equity gains and could quickly erode the hard-won improvement in confidence once again.

This ties to the rising exports volumes seen this year and China’s overall, large trade surplus. As mentioned earlier, devaluations tend to happen to boost exports. However, China’s exports are rising again after facing a sharp set-back last year. In addition, China in 2023 had a trade surplus of 5.4 per cent, hardly suggesting a lack of competitiveness or great urgency to boost exports through a devaluation. The nominal effective CNY is quite strong -  however it is also true that it has recently weakened in real terms due to low Chinese inflation.

Devaluation could also add fuel to the fire in trade tension with EU and the US, especially in light of the significant trade surplus that China currently has. The EU is already in the process of imposing duties on Chinese EVs. And US President Joe Biden, who is facing off with Donald Trump in the November election, would be under pressure to punish China for such a move by raising tariffs. This would quickly erode the benefit of a devaluation for China.

Last but not least, a deliberate devaluation could trigger a currency war with other countries, not least in Asia, where a 5-10 per cent slide in the CNY could trigger a 3-7 per cent drop in the currencies of other export countries in the region. China prides itself for not devaluing at any point during the 1997-1998 Asian crisis, when it saw currencies among its’ Asian counterparts depreciate very fast. China likes to see itself as a responsible actor in the Asian region, one that contributes to economic and financial stability rather than the opposite. Part of China’s arguments for not devaluing during the Asian crisis was that it would trigger counter-devaluations and fuel instability.

While it can be argued that China needs to take bigger steps to underpin the economy, what is mostly needed are measures that support domestic demand rather than temporary measures that may do more harm than good in the long term. It would serve the purpose of both benefitting China as well as benefitting trade partners and foreign companies - and thus help mitigate some of the US and EU critique of its rising exports, continued high trade surplus, and lack of domestic demand. China this year is expected to roll out a trade-in scheme for consumer goods with exactly that aim.

As a result, the expectations remain for a continued a gradual weakening of USD/CNY. China should continue to aim for a gradual increase in the cross-currency fixing to avoid the risk of instability. It can do this by allowing for a slow rise in the daily fixing. This would meet some of the depreciation pressure in the market but avoids disruption that could undermine financial stability.

There are of course risks to this view. Policymakers might have changed their mind about the right FX policy and see the need to make a risky move through a devaluation that could allow them to cut policy rates more aggressively. It would be a clear change in strategy though, and an unusual move from a leadership that since the Global Financial Crisis in 2008-2009 has moved in cautious steps and who sees fiscal and industrial policy as the preferred tools to meet China’s goals of supporting demand and the long-term goal of a high-tech economy.

Another risk factor could be if the US economy performs stronger than expected and, instead of cutting rates, starts raising them again. It would add further upward pressure on USD/CNY and could make the PBOC eventually give in to the depreciation pressure. Finally, a third risk factor could materialise next year if Donald Trump returns to the White House. He might restart the trade war and increase tariffs on China significantly, which would trigger renewed depreciation pressure on the CNY.


Affinity Research LLP