Chinese Yuan Forecast 2016: Stealth Devaluation Could Ignite Turmoil

Yuan Forecast 2016Bearish Chinese Yuan Forecast for 2016

China’s central bank, the People’s Bank of China (PBOC), has set the value of the yuan at 6.414 per U.S. dollar, the lowest value set since August 2011. Beijing said that its currency devaluation was motivated by stress tests, officially. However, there was nothing unpredictable about the move, considering that the yuan was recently included as an official special drawing rights (SDR) currency by the International Monetary Fund (IMF). But what should investors expect from the Chinese yuan forecast in 2016?

As has been the case in the past year, inflation remains high, even though the actual production values of assets are dropping. The PBOC has fixed the yuan’s exchange rate with the dollar (within the expected target range between plus two percent and negative two percent), reaching the lowest level since 2011. However, this is just another example of the many (and so far ineffective) maneuvers the government has adopted in the last 12 months to create a lasting structural effect on the entire economy. Regardless, industrial production isn’t taking off.

Both China’s foreign exchange reserves and exports have dropped, while many enterprises have plummeted. These are clear signs of the Chinese economy’s weakness, which could lead to further PBOC stimulus interventions. (Source: “Loss-making Chinese firms help investors hit the jackpot,The National, December 10, 2015.)

Lower Yuan Could Backfire

In short, Beijing’s devaluation to stimulate exports against the likelihood of an even stronger U.S. dollar resulting from the Fed hike has caused a flight of Asian investment to shift toward the United States, where it would be better remunerated, presumably. Many investors are already starting to liquidate their investments in China and Japan to avoid being hit by declines in a few days. (Source: “Chinese devaluation is a bigger danger than Fed rate rises,The Telegraph, December 9, 2015.)

The boomerang devaluation was largely predictable because China’s central bank had to pay dearly to stabilize the yuan, coughing up some $130 billion in August alone. Moreover, China was under pressure not to devalue the yuan, because the government in Beijing wants to attract more foreign capital, as it prepares to host the G20 summit.

Meanwhile, the overly weak dollar is going to feed criticism of China from the United States, as some candidates—we’re not saying whom, but you might know him very well—push their products to gain a bigger share of the American market. In other words, China can be portrayed as an interventionist.

Yi Gang, deputy governor of the central bank in China, promised that Beijing “will continue to keep its currency stable at a reasonable equilibrium intervening only to curb excessive volatility.” (Source: “China Sets Yuan at Four-Year Low in ‘Stress Test’,” The Wall Street Journal, December 9, 2015.)

The problem is that fluctuations are a precursor of more trouble, sending a message to the markets that the yuan is overvalued relative to its purchasing power, forcing Chinese companies to cut prices and take the lowest wages to remain competitive in a move that evokes the specter of deflation.

At the same time, the central bank must address the risk that Chinese companies may not be able to repay their dollar-denominated debts. This will also have an impact on the currencies of China’s Asian trading partners. Moreover, less favorable trade statistics and the strong likelihood that the Fed will effect a rate increase might certainly be a concern for Washington. In China, the move will clearly be seen as a stimulus for export growth.

As for foreign currencies, in November, China’s treasury held the lowest level in the last two years. Nevertheless, Beijing has accumulated a vast sum of foreign currency over the years in which trade, driven by strong demand, has helped the central bank hoard instruments from U.S. government securities to equity investments, such that China has room to maneuver, either by keeping the yuan stable or letting it float to absorb growing economic pressures.

However, by allowing the yuan to become an SDR currency, Beijing has also been forced to relinquish the “parachutes.” In other words, it has less control than before to manage economic policy and it is more prone to financial shakes. It is no longer realistic for the central bank to believe it can retain the ability to absorb the peaks and valleys of the world economy as it has in the past.

Is China Getting Desperate?

China is desperately trying to stop capital flight ahead of the Fed meeting. As the world focuses on the U.S. Federal Reserve and its much-anticipated interest rate hike (however minimal), the yuan may be the currency to watch. The Telegraph’s Ambrose Evans-Pritchard says that Beijing’s economic fundamentals may warrant further write-downs of the yuan. (Source: “Chinese devaluation is a bigger danger than Fed rate rises,The Telegraph, December 9, 2015.)

If the dollar were to revalue, the effort to support the de facto peg to the dollar would be too onerous for the PBOC. Bank of America expects the yuan to drop to 6.90 against the dollar (from the current 6.43), while Japan’s Daiwa fears a devaluation of 20%, triggering concerns that the yuan may be overvalued. (Source: Ibid.)

Capital outflows from the People’s Republic of China were $113 billion in November alone, costing the PBOC (according to estimates by Capital Economics) about $57.0 billion in sales of foreign reserves in order to support the exchange rate. (Source: “China saw record capital outflows in November,” CNBC, December 7, 2015.) Such exchange rate support is too expensive, even considering China’s substantial yuan reserves. Chinese exporters are trying to keep their earnings in dollars and the devaluation will only reduce their willingness to receive payments in yuan.

Ultimately, it is not easy to determine whether the yuan is overvalued, according to Evans-Pritchard. The yuan is pegged to the U.S. dollar and as such, the PBOC had little choice but to follow it, even if it would rather have sought relief. The fact that Japan devalued its yen only made matters worse. Ultimately, Chinese enterprises have been forced to succumb to lower profit margins.

The official commitment of the Chinese authorities is to maintain a stable exchange rate, a task that the yuan’s SDR ambitions has made more difficult, because the PBOC has less flexibility.

The bottom line: the Chinese yuan forecast for 2016 is absolutely bearish.

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