China in Transition

# Concerns over Accelerating Capital Outflow and Intensifying Trade Friction with the United States Caused by the Depreciation of Yuan

Chi Hung KWAN
Consulting Fellow, RIETI

The exchange rate of the yuan against the U.S. dollar has been trending downwards since the yuan was devalued by a total of 4.4% over three consecutive days from August 11, 2015. Compared with the level before the devaluation, the yuan has already depreciated by approximately 12% against the dollar. Although the trigger for the weaker yuan was capital outflow from China, additional factors such as the victory of Donald Trump, the Republican Party candidate who ran on a slogan of "making America great again" in the U.S. presidential election on November 8, 2016, and the decision of the Federal Open Market Committee (FOMC) on December 14, 2016 to raise interest rates for the first time in a year are also driving the depreciation of the yuan. The Chinese authorities are intervening in the exchange market by selling dollars and buying yuan to stabilize the exchange rate, and foreign exchange reserves are declining sharply as a result of the intervention (Figure 1).

Since the U.S. presidential election, however, the dollar has risen not only against the yuan but also against most major currencies (Figure 2). Above all, the depreciation of the yen against the dollar has been significantly larger than that of the yuan. However, while the weaker yen is welcomed as a factor to put the Japanese economy back on the track for recovery through growth in exports, the weaker yuan is regarded as a sign of vulnerability in the Chinese economy and is seen as a potential economic destabilizing factor. Why are the market reactions to these two currencies so different?

## Is a weaker yuan good or bad for China?

In principle, a sharp depreciation in the home currency (against the dollar) will result in an increase in the cost of servicing external debt (in the home currency) for developing countries with large debts denominated in foreign currencies (particularly dollars), eventually creating the risk of a financial crisis. Thailand and Indonesia at the time of the Asian currency crisis are typical examples. However, China is a net creditor nation like Japan, with reserve assets of more than $3 trillion (most of which are foreign exchange reserves) (Table 1). In addition, because most of its external debt is in the form of direct investments by foreign companies (which do not have a repayment obligation), it is unlikely that the weaker yuan will trigger a financial crisis. China's export competitiveness actually would be improved by the weaker yuan. In fact, its export value (in dollars) in November 2016 rose by 0.1% year on year, the first year-on-year increase in eight months. Table 1: China's International Investment Position (as of the end of June 2016) Amount ($ billions) Share (%)
Assets (a) 6,311.4 100.0
Direct investment 1,251.5 19.8
Portfolio investment 306.5 4.9
Reserve assets 3,303.2 52.3
Others 1,450.2 23.0
Liabilities (b) 4,647.7 100.0
Direct investment 2,908.2 62.6
Portfolio investment 783.9 16.9
Others 955.6 20.6
Net external assets (a)-(b) 1,663.6 -
Source: Compiled by the author based on the "time-series data of the International Investment Position of China" of the State Administration of Foreign Exchange of the People's Republic of China.

## A vicious circle of weaker yuan and capital outflow

What China should be concerned about is the vicious circle of weaker yuan and capital outflow, rather than the depreciation of the yuan itself. For a long time, foreign exchange reserves continued to increase in China as not only the current account, but also the capital and financial account, had been in surplus. However, with the capital and financial account trending toward a deficit since 2014, reflecting the accelerated capital outflow, foreign exchange reserves have been declining since 2015 (Figure 3). While the ongoing capital outflow has not only led to a weaker yuan but has also raised expectations that the yuan will further depreciate, the expectations of a weak yuan in turn have prompted further capital outflow.

## Is China a currency manipulator?

With the yuan depreciating, U.S. President-elect Donald Trump has clearly stated that he will declare China a currency manipulator, claiming that the depreciation of the yuan is a deliberate policy of the Chinese government. If the incoming president were to take this line, trade friction between the United States and China would intensify.

Based on the U.S. Department of Treasury's semiannual report on international economic and exchange rate policies, the U.S. Congress decides whether to declare a country that manipulates its exchange rates unduly by intervening in foreign exchange markets for the purpose of turning its trade with the United States in its favor a currency manipulator. The U.S. government is able to impose sanctions on the country that has been declared a currency manipulator in the form of tariffs and demand a revaluation of its currency. It has become increasingly likely that China will become a target under the Trump administration.

Although the Chinese authorities did indeed try to curb the appreciation of the yuan for a long time through market intervention in the form of buying dollars and selling yuan, they have switched to a policy of trying to halt the depreciation of the yuan through selling dollars and buying yuan, following the change from upward pressure on the yuan to downward pressure after mid-2014. One could argue that this is a form of currency manipulation, although it is fundamentally different from Trump's claim that China is allowing the yuan to weaken in foreign exchange markets to increase the international competitiveness of Chinese products.

## Shifting to a free floating exchange rate system as an effective solution

It has become an important policy issue for China to break the vicious cycle of a weaker yuan and capital outflow and avoid trade friction with the United States. A shift to a free floating exchange rate system would solve the problem. If the authorities were to leave the exchange rate of the yuan up to market supply and demand without intervening, China would be able to avoid seeing market expectations becoming entirely bullish or bearish because expectations for a weaker yuan and a stronger yuan would be always in balance. At the same time, China would no longer be criticized as manipulating exchange rates. Thus, the shift to a free floating exchange rate system for China would be a measure that kills two birds with one stone.

The original text in Japanese was posted on January 10, 2017.

January 31, 2017

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