Sustainable or Sisyphean? The Outlook for China’s Currency Defense

China’s currency outlook is a critical question for both financial markets and economic policy-makers today, in light of fears that China may contribute to global deflation. Since August 12 the People’s Bank of China (PBOC) has supported the yuan by selling tens of billions of dollars in foreign exchange onshore and offshore while senior Chinese leaders have — across the board – pledged not to embrace a depreciation strategy.

That effort intensified last week, as the PBOC forced the largest intra-day appreciation of the yuan through considerable volumes of USD sales on Friday, October 30, driving the currency 0.6% stronger to 6.3181 per dollar and demonstrating the Chinese leadership’s commitment to the yuan’s defense. Then, just as abruptly, the market almost completely reversed this move on Monday, particularly offshore, putting the effectiveness of short-term intervention in doubt and fueling depreciation expectations despite PBOC guidance.

The key question now is whether China’s efforts to defend the currency are sustainable over the medium-term or a lost cause that must give way to significant depreciation within months. We have divergent views on this critical question at Rhodium Group: rather than try to reconcile them, we feel it is far more valuable to clients to lay both sides of the argument out. Logan Wright argues below that the yuan will need to depreciate further in a meaningful sense against the dollar, perhaps by 10-15%, to restore stability to China’s balance of payments and the capacity of Chinese authorities to regain control over domestic monetary conditions and slow the ongoing deflationary cycle.

Dan Rosen argues, instead, that China’s leadership is weighing the costs of lost policy credibility from breaking recent commitments most heavily, and will attempt to sway balance of payments fundamentals with structural reform. Dan argues that any meaningful devaluation would be hugely counterproductive, and weaken the credibility-dependent financial system by exacerbating capital outflows and triggering competitive counter-devaluations abroad while producing no improvement in China’s competitiveness.

Posted August 1, 2017
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