Chinese Forex Reserves are Sliding & Currency Depreciating: China Series 2

Despite of China intervening in Forex market by selling USD to keep currency stable.

As stated in my previous blog, Chinese forex reserves are sliding and currency depreciating. This is despite of China intervening in Forex market by selling USD to keep currency stable and putting Capital controls to ensure that people and corporations don’t take money outside China.

Two obvious questions that come to mind.

  1. How does it matter to us outside China, whether in India or other parts of the world?
  2. If it matters to us, how will it pan out in 2017

Answer to the first question. We are living in a very inter-connected and inter-dependent world. Any crisis in the world’s second largest economy and the largest trading nation, which also happens to contribute about 1/3rd of world’s growth, will impact every country on the globe and especially very severely emerging market economies and commodity economies.

Answer to the second question is somewhat tricky, since China is and has always been somewhat a mystery. Data and other economic indicators published by the Chinese Govt. may not reflect the true state of the economy. Hence answer to this question is, what all, including but not limited to currency depreciation and forex reserves, could go wrong for China and what could be possible responses of China.

Currency depreciation and forex outflow can start a downward spiral of markets in China. However, there is no possibility of balance of payment crisis. China can act in combination of following three things:

  1. Increase the interest rate so that foreign debt investments desperate for higher yield (net of hedging cost), still finds China lucrative, especially if US fed raises interest rates.
  2. More capital controls: More scrutiny of outward investments and loans, closing in on existing loop holes and curbing individual outward limit of $50000 per year. China can put significant controls in place to curb forex outflow.
  3. Intervention in forex market: China has already burnt about a $1tn to curb sharp decline in value of Renminbi in last about 18 months. All indications by the central bank are that China will not hesitate to burn more reserves to ensure that there is no sharp depreciation of Renminbi. An orderly and gradual decline in the value of Renminbi is welcome though.

My take on this is, China should be able to manage this as current forex reserves of $3tn plus are more than adequate.

If there is a significant depreciation in Renminbi from here on, let’s say, to 7.3 or so. It will impact other emerging markets severely, especially South east Asia and Latin America.

However, if President Donald Trump is able to:

  1. Move to Fiscal stimulus from monetary stimulus and
  2. Reduce corporate tax rates

In that case Interest rates in US will go up at much faster rate and capital will move back to US at a rapid pace. The Chinese govt. will have to be ahead of the curve to take action to counter the situation. Action could be combination of all three options mentioned above.

Will talk about other risks that China is facing in my next blog. Keep reading

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