As on date much has been talked about Evergrande and its contagion effects but how does contagion effect get triggered is the key point. While the whole media claims that “What happens in China remains in China” but the situation as on day is telling us different Scenario.
Before going into depth of Contagion effect of Currency, we should go into simplified things that how a trade cycle goes on for import and export & how real estate was a driver for growth:
Demand and Supply
Since Real Estate had direct contribution of 30% on Chinese GDP but indirect contribution cannot be under estimated. The use of Cement, Steel , Glass, Chemicals etc in construction created robust demand and resulted in huge utilisation of expanded capacity.
As per WTO data, China is the worlds largest exporter and second largest importer.
Source: IMF, World Economic Outlook ; Latest available data
Main Partner Countries
Note: Nations like Japan(Steel, Paint, Electrical Item), Australia (Iron Ore) and Germany (Capital Goods) are more or less dependent on Chinese Real Estate.
From the above data, it is clearly visible that Chinese Yuan directly or indirectly influence the value of U.S. dollar by loosely pegging the value of its currency. The Central Banks in China uses a different kind of version of Currency rate which is Fixed in nature in the mainland of China while the offshore market has a floating rate which usually carries less than 2-3% premium even at the times of adverse circumstances.
Role of Chinese Central Bank (PBOC)
The Peoples Bank of China (PBOC) usually manages the value of Yuan. It keeps it fixed to a basket of currencies reflecting its trading partners.
Eg:If it exports to Australia value of CNH 644 goods, UK CNH 1288
Or Yen 2000 goods then PBOC keeps value each currency i.e AUD, Pound or Yen (Basket of currency) to CNH at fixed rate irrespective of fluctuations of in cross border currency transaction of different currencies like USD to AUD or USD to British Pound in our example.
Then comes the role of Reserve currency i.e Dollar. Since Dollar carries 60% weight in the global currency transaction, the weight of Dollar in Chinese transaction will be highest too.
The basket is weighted toward the dollar. It keeps the yuan’s value within a 2-3% range against that currency basket.
China manages its currency to control the prices of its exports. Therefore, for last many decades China has exported deflation Globally and imported inflation within its own territory. And similarly, every country would like to do this, but few have China’s ability to manage it so well. As the same creates growth within the nation in the name of depreciation of purchasing power.
On Aug. 11, 2015, China all of a sudden announced Devaluation of its currency. The reference rate previous day Yuan rate in offshore market was used as onshore rate. At that time the premium rate between offshore and onshore yuan was more than 3% and further it’s a step to get added to get added as a part of IMF’s special drawing basket which is a move towards supplementary . This led to a greater market Volatility. The International Monetary Fund (IMF) added the CNH to its Special Drawing Rights basket, a supplement of official reserve currency for different countries.
How China Manages Its Currency
China’s currency power comes from its many exports to America accounts for 16.80%. The top categories are electrical machinery, machinery, and furniture and bedding. Also, many American companies exports raw material to various factories in China for low-cost assembly. This Accounts for roughly 6% of Chinese import. The finished goods are then Exported globally after the assembly of Semi Knock Down products or Complete Know Down products. That’s how the U.S. trade deficit with China is profitable to American companies.
Eg: Suppose Mr X is US businessmen. If he wants to make a product D in US then it will cost $22 per piece which includes $10 as wage rate. However, if he set up a factory and export Material in Semi Knock Down stage or Complete Knockdown Stage in China for Assembly then the same product could have costed him $15 (after shipment) as wage rate in China is one third of US say $3 in our example. The same product he exports it to various other countries from China and will earn huge margin even if it sells those product at $20. So, the raw material sent to China is Import for China and finished goods sent back to US or other nation from China is Export for China. Though it resulted into Trade deficit for US companies but still the margins are huge.
Now under our example, Chinese firms will receive 20 dollars as payment for their exports but they need to repay $12 for Material imported from China. So the firm deposit that $8 into local banks say Bank of China, in exchange for 52 yuan (Taking USD to Yuan at 6.46), which can be used to pay their domestic workers and vendors. The local banks then send the dollars to China’s central bank (PBOC).
Till above explanation, things are similar globally. Now the question is how does the fixed rate remained same while the fluctuation in foreign currency is high?
Just before the Asian Currency crisis, South Korea, Thailand, Indonesia and few other Asian nations got abnormal flow of currency and all of a sudden when interest rates increased the foreign creditors demanded dollars back but those dollars were used for meeting Infrastructure and other needs. That resulted into huge devaluation of Pegged currency.
Well, if a country is Manufacturing hub, large amount of reserve currency will inflow to that country if has highest share of Exports. So PBOC holds the dollars in its foreign exchange reserves and regularly adjusts these reserves by buying or selling dollars via foreign currency markets in exchange for yuan. By stockpiling dollars, the PBOC reduces the supply of dollars available for trade, putting upward pressure on the dollar and downward pressure on the yuan and vice versa.
It is important to note that the Central Bank of China (PBOC) does not sit on cash reserves (The percentage of cash required to be kept in reserves as against the bank’s total deposits, is called the Cash Reserve Ratio). It uses the dollars it accumulates to buy U.S. Treasuries, which are safe-haven assets that provide some incremental return over cash.
Before 2008, had it been same thing in case of China (Worlds largest manufacturing hub) could have given real cushion over 1997 Asian Currency crisis moment. But never the less, at present Chinese GDP is 30% directly dependent on Real Estate so that also involves lots of foreign dollar absorption into the economy which was creating notional increase in value of assets to give benefit to Yuan. But in reality, it’s a wealth disparity gap wherein the investment in real estate has reduced velocity of money. More than 74% of household wealth is into real estate. So whatever invested in real estate becomes sunk cost for the country unless and until real demand and supply comes into picture.
Market forces and China’s currency management efforts can lead to wide fluctuations in the value of the yuan.
Just like 2015 case where China devalued its currency and lost more than $1 trillion reserves in this process to restore the yuan’s value, the PBOC used its dollar reserves to buy yuan from Chinese banks.
By taking the yuan out of circulation, the Bank raised the currency’s value. At the same time, it lowered the dollar’s value by putting more dollars into circulation.
Similarly in January 2016, China further relaxed its control of the yuan. The uncertainty over the yuan’s future contributed to the Correction in Global Markets on a single day
By 2017, the yuan had fallen to its lowest point since 2008. But China wasn’t in a currency war with the United States. Instead, it was trying to compensate for the rising dollar. Between 2014 and 2015, the dollar rose 11.8%. Because it was pegged to the dollar, the yuan followed it. China’s exports became more expensive than those from countries not tied to the dollar. It had to lower its exchange rate to remain competitive.
China’s economy impacts the dollar’s value in other ways. China’s slowing economy is one reason why the dollar gained strength in 2014 and 2015. Further the appetite of Chinese Stock market is another reason. If the market crashes in China then the tremors of same can give shocks to other currencies too.
China’s leaders need to avoid inflation and future collapse. Due to large amount of liquidity into state-run companies and banks, they’ve invested those funds into ventures that aren’t profitable.
China’s economy has a large amount of corporate debt. Many of these loans are above the lending limits set by the central government. They aren’t on the books and aren’t regulated. They could all default if interest rates rise too fast or if growth is too slow.
China’s mega-rich want to escape this threat. They are investing in U.S. dollars, other first world real estate and Treasury Bonds as a safe haven investment.
At the end we can say it’s a double whammy situation for China as the Emerging market countries rely on exports to China to fuel their growth. As China’s growth slows, it will hurt some of these trade partners like Japan, Australia or Germany more than others. As these countries’ exports slow, so will their growth, FDI (Foreign Direct Investment) will also drop as opportunities dry up. Slowing growth weakens these countries’ currencies. Forex traders specially Banks of other nations may take advantage of this trend to drive currency values down more since the velocity of Money is at all time low level and those businesses taking dollar loans would end up paying more principal amount then the required one. This could further strengthen value of dollar.
After all it is perfectly said that the cause of Bubbles will change but the nomenclature of bubbles will always remain same. Earlier US imported from Europe, then it was Japan and now its China. Only Countries Change but bubble remains same.
- By Nishant Maheshwari, Vishal Vora
Disclosure: The views expressed here are those of the authors and should not be construed as a financial advice. This article is for information only.
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