By John Richardson
THERE is a 50% chance that the Yuan will become a freely trade currency in 2017 in response to the US signalling its willingness to start a global trade war, says Societe Generale.
If Donald Trump pedals back on his rhetoric and/or Congress gets in the way of his plans and we avoid a trade war next year, the French bank still sees a 20% chance that the Yuan will be freely-floated in 2017. This would be followed by a much bigger potential for trade liberalisation in 2018 and 2019 (see the above chart).
What would this mean for the strength of China’s currency? So far this year, the Yuan has depreciated by 6.2% against the dollar. Societe Generale’s base case is for it to fall to 7.3 against the greenback by 2015 – a further decline of 5.6%. Deutsche Bank expects a further 17% devaluation by the end of 2018.
These could turn out to be accurate estimates. But the trouble is markets have a habit of behaving in erratic and exaggerated ways, and so why not a much bigger devaluation?
Why might China decide to entirely liberalise trading in the Yuan through removing all of the government restrictions, or “circuit breakers”, that prevent the market from entirely setting its value?
The Chinese Yuan has of late been falling in value as a result of growing capital outflows that reflect declining investment opportunities in China, adds the bank.
There is of course another more recent reason for capital flight: The dollar has strengthened because of Mr Trump’s inflationary plans to cut US taxes and boost infrastructure spending.
This has led to restrictions on capital outflows. However, Societe Generale economist Wei Yao said: “Given the a large domestic money stock that is still growing much faster than nominal GDP, as well as the increasingly stretched valuations of many domestic assets, it is going to be an uphill battle for the Peoples’ Bank of China to retain controls over the speed of currency adjustments..
“We do not believe that capital controls can have a lasting effectiveness for an economy of China’s size and complexity.”
The other alternative is to use foreign reserves to prop up the Yuan, but China’s foreign reserves are declining and Deutsche Bank believes that they will eventually fall to $2.5 trillion from today’s $3.1 trillion.
China cannot risk squandering these reserves because, as I have been pointing out since last year, its reserves are substantially less than its liabilities. These liabilities, or debts, have further increased in 2016 as a result of the re-inflation of the property bubble.
Free floating the Yuan would halt the drain on reserves. This shift would also be in line with China’s desire to become a more open, market-based economy.
In the event of new US trade barriers, China would bring forward free floating the Yuan to as early as 2017, continues the bank.
But Societe Generale argues that because of the above pressures, it is only matter of when rather than if China free floats its currency. Hence, its alternative scenario of high percentage chances of this happening in 2018 and 2019.
This further underlines that whatever you think of Mr Trump’s policies, his departure from the the economic and geopolitical consensus in place since the Second World War will cause major disruptions to the global economy.
You can instead hold the view it will be “business as usual”, and that events such as a steep fall in the value of the Yuan are tail risks so remote that they are not even worth considering.
This is entirely the wrong approach. What you must do is to plan for a world where the Yuan falls very significantly in value. The headline for this blog post
Here are just five of many consequences that you need to take into account.
- Mr Trump’s government responds with wave after wave of protectionist measures against China.
- Election results in Holland, France and Germany in 2017 are influenced by the fall in China’s currency. This leads to protectionist measures in Europe against more competitive Chinese imports.
- China responds in kind and we end up with a trade war that leads to a global economic recession.
- Drilling down to the chemicals industry, China is able to run its plants much harder for export purposes, thanks to the weaker Yuan. This leads to big increases in exports of the products in which it is in surplus, such as polyvinyl chloride and purified terephthalic acid – until, of course, trade barriers are erected.
- Meanwhile, imports of the products where China is in deficit – such as polyethylene and polypropylene – decline because the weaker Yuan makes them less affordable. Local production is maximised to help fill the gaps.
You need some firm data behind this scenario, and other scenarios. This is where ICIS Consulting can help. Contact me at john.richardson@icis.com