Macroscope | China must avoid another big-bang yuan devaluation

Ever since Japan’s government began intervening in the currency markets in April in response to the plunge in the yen to a fresh 34-year low against the US dollar, speculation about a sharp devaluation of the yuan has intensified.

That the prospect of a shock depreciation of the yuan – an anchor of stability for other currencies in Asia and an important part of President Xi Jinping’s plan to bolster China’s position as a financial powerhouse – is being taken seriously by some investors speaks volumes about the acute challenges facing China’s economy.

The yuan has suffered because of the US Federal Reserve’s determination to keep interest rates higher for longer to stamp out inflation, fuelling a sharp rally in the US dollar. The wide gap between US and Chinese borrowing costs has contributed to the collapse in foreign direct investment in China. In April, capital outflows rose to their highest level since 2016 as banks sold more foreign currencies to their clients.

China’s cyclical and structural economic woes have put further strain on the yuan. Morgan Stanley notes that China is on course for the longest period of deflation since the late 1990s, with price increases likely to remain below 1 per cent in 2024 and 2025, “far below the 2-3 per cent [levels] we deem as moderate levels of inflation conducive for the overall macro [economic] environment and managing debt-deflation loop risks”.

This puts pressure on the People’s Bank of China (PBOC) to keep loosening monetary policy. This is mainly because of the threat posed by deflation rather than the need to boost exports, which have proved surprisingly resilient this year. China’s real, or inflation-adjusted, interest rates rose sharply last year as prices fell at a much faster pace than average lending rates for households and businesses. In its latest review of China’s economy, the International Monetary Fund noted that financial conditions “remain modestly tight”.

An additional source of pressure on the yuan is the prospect of more tariffs on Chinese goods than the ones already levied by the United States and European Union. The Chinese currency is a key gauge of risks surrounding tariffs and exchange rates, especially given Beijing’s pivot towards a growth strategy focused on high-end manufacturing that relies heavily on exports.