Thursday, August 13, 2015

Lessons for China From Past Currency Peg Mistakes
Gene Frieda
Financial Times

With the US Federal Reserve’s first rate rise approaching, China’s belated decision to allow the renminbi to depreciate bears hallmarks of the Swiss National Bank’s pre-emptive reaction to European quantitative easing in January. The lessons from other discarded currency pegs loom large.

The lesson from Asia and Latin America in the 1990s was that currency pegs reinforced and indeed exacerbated financial cycles. Asset prices tended to overshoot on the upside, creating macro imbalances that were eventually corrected through catastrophic devaluations.

There are both parallels and differences to China’s case. The similarities are that China experienced a nearly decade-long appreciation against the dollar and most of its trading partner currencies. The trend was characterised by low volatility and high predictability.

Incentives to speculate accordingly were large. Foreign capital, often disguised as trade or direct investment flows, circumvented capital controls to enter the real estate market. And after 2008, Chinese corporates began to borrow more aggressively abroad.

Unless the currency peg is dissolved at a point in the cycle when balance of payments flows are reasonably balanced, the de-peg tends to release any volatility that has been stored up, and the currency tends to overshoot in the direction against which the central bank has been leaning. In the Chinese case, as with Asia in the 1990s, the direction is now clearly weaker.

But the differences are key as well. Unlike Asia in the 1990s, the renminbi shows few signs of overvaluation in its external balances. The current account surplus, while well down from its peak of 10 per cent of GDP in 2007, is still 3 per cent of GDP. And Chinese exports have continued to gain market share globally.

Instead, the currency peg is inconsistent with internal balance, reflective of a growing debt overhang and impending balance sheet recession. The corporate sector is buckling under the weight of a heavy debt burden and worsening producer price deflation. July marked the 40th consecutive month of deflation, and the trend worsened to a year-on-year fall of 5.4 per cent.

Depreciation pressure is about industrial overcapacity born of excess investment. Corporates are suffering from weak global trade demand, worsening profitability as labour costs rise and high debt financing costs.

The other key difference between China and past peggers is that the capital account has been less liberalised. China’s foreign debt liabilities, measured at around $1tn, still pale in comparison to foreign reserves of $3.6tn. But scope for domestic capital flight is huge given the high degree of monetisation in the economy. M2 money supply, a measure of cash and short-term monetary liabilities, measures more than 200 per cent of GDP, or nearly $22tn.

Modest domestic capital flight coupled with an unwind in foreign borrowing can make a serious dent in foreign reserves, impart significant depreciation pressure, or both. The strength of China’s foreign reserve buffer should not be overestimated.

Accordingly, China finds itself in similar circumstances to past peggers, but with distinct advantages: a large foreign reserve buffer and a less liberalised capital account. The decision to allow the renminbi to respond to market pressure for depreciation is belated, but positive. China should heed the Swiss lesson to allow the currency to find a new equilibrium, intervening modestly to smooth the fall rather than to prop the currency up at levels inconsistent with domestic fundamentals.

To re-establish a stable equilibrium, the authorities need to resist the temptations of premature capital account liberalisation, write down bad debt and, once and for all, remove the implicit guarantees on lending to the state sector that have been a key driver of capital misallocation during previous Chinese administrations.

When central banks unleash volatility on markets, it is rarely positive for risk assets. In this case, the duration of that weakness will largely depend on China’s other reform choices. Without reforms, currency depreciation pressure will only build rather than abate. And more pressure will be brought to bear on central banks in Europe, Japan and emerging markets to lean against this pressure with depreciations of their own.

Gene Frieda is a global strategist for Moore Europe Capital Management

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