Yuan’s depreciation is a self-fulfilling prophecy

By Li Daokui Source:Global Times Published: 2016/11/17 21:33:39

Illustration: Peter C. Espina/GT

Illustration: Peter C. Espina/GT

Recently, the Chinese currency plunged sharply, hitting a fresh eight-year low against the dollar on Wednesday after dropping for nine days in a row. Against all popular explanations for the factors that have led to the depreciation of the yuan, I would argue that it is the impact of market expectations, which proves to be a self-fulfilling prophecy. To address the situation, China should properly manage investors' expectations and capital flows in the short term. Over the long term, it should take concrete measures to reduce the country's monetary stock and fundamentally stabilize the financial system, which is the foundation of the yuan's internationalization. The cornerstone of the yuan's internationalization is financial stability rather than flexibility of exchange rate and free capital flow. 

Currently, there are some popular explanations about what is contributing to the pressure on the yuan. These include expectations of the Fed rate hike in December, pressure from China's weak foreign trade, massive capital outflows due to Chinese companies' quickening pace of "going out" and the buildup of a property bubble which has prompted Chinese homebuyers to turn to overseas property markets. Additionally, some analysts believe that the overall return rate of China's financial assets is rather low, which pushes investors abroad for investments that offer higher returns. But none of these explanations stand up to close scrutiny. Take the pressure from China's weak foreign trade, for example. Some observers argue that the Chinese government expects to boost exports through devaluation of the yuan. But the argument does not hold up. China is still a country with a current account surplus. The Chinese government would become a target in the international policy arena if it sought to boost exports and widen its trade surplus through currency devaluation. Further, Chinese leaders have pledged international responsibility as they participate in bilateral and multilateral policy consultations. It is unlikely that they would seek to stabilize the economy through yuan devaluation. Moreover, China's export to GDP ratio has dropped considerably since the 2008 financial crisis. It would not be a feasible policy option to pump up the economy and exports through yuan devaluation.      

So what has led to the pressure on yuan depreciation? I would suggest it is actually market expectation at work. 

There is a popular view that the quality of China's financial assets is low given the decline of bank profits caused by bad loans and poor profitability of listed companies, which in turn has caused capital outflow and yuan depreciation. With the expectation of yuan depreciation, investors will then diversify their currency holdings as they allocate assets.

As this view becomes increasingly popular, it creates a self-fulfilling cycle of depreciation - depreciation expectations generate actual capital outflow, which reinforce the expectation of yuan depreciation in the forex market. Such a self-fulfilling loop is nothing new in the forex market.

Currently, the yuan exchange rate regime yields multiple equilibrium. When we expect the yuan to depreciate, investors will exchange large amounts of yuan into dollars, causing massive capital outflow and further depreciation. If we expect the yuan to remain stable, cross-border capital flow and the exchange rate will be relatively stable. The subtlety that causes the equilibrium is that liquidity in China is the highest in the world. If there is any sign of change in exchange rate expectations, the huge liquidity in the yuan translates into pressure on cross-border capital flows.    

Such a situation calls for moves at a policy level. In the short term, Chinese regulators should properly manage expectations and convince the market that there is no fundamental basis for the yuan depreciation. That means at a policy level, China should keep the yuan stable against the dollar, with depreciation not exceeding 3 percent each year.

In the medium and long term, China should change the structure of its financial asset holdings, gradually converting dollars into other financial assets, particularly bond-oriented assets. Compared with high liquidity assets such as cash and bank deposits, other financial assets will not easily flow out of the country under yuan depreciation pressure. For example, if half the liquid assets were converted into bonds, bond holders may sell because of the risk of capital outflow, which will push up the rate of return, automatically creating a feedback mechanism. That will cause investors who sell off bonds to think twice before further dumping and reduce the pressure of capital outflow. A practical way is to encourage best-performing companies to issue bonds and increase treasury bond holdings to allow companies to borrow money through bond issuance instead of bank borrowings.

Why are attempts at reducing liquidity and maintaining financial stability in China not encouraging capital to enter the stock markets or the new third board? This is because the institutional foundation of the Chinese stock markets, including the new third board, is weak. Once massive capital enters the stock markets, stock prices will fluctuate violently. This is definitely not a good thing for the Chinese economy.

The author is director of the Center for China in the World Economy (CCWE) at Tsinghua University. bizopinion@globaltimes.com.cn


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