THREE hundred and twenty billion dollars. That is the amount by which China’s gargantuan foreign exchange reserves declined by in 2016, according to the latest data that has been made available by the People’s Bank of China. Chinese reserves, which peaked at $4 trillion in mid-2014, have fallen to $3.011tr, their lowest level since March 2011. The steep decline in reserves and a weakening yuan could create significant global economic headwinds.
Markets function as a herd. Euphoria can quickly give way to panic, and people’s perceptions can lead them to take actions that create facts in line with their perceptions. The present perception is that the yuan is overvalued and that China’s central bank will continue to intervene in the market to manage the currency’s decline.
The decline in the yuan began in August 2015 when the Chinese authorities made a surprise move, allowing the currency to depreciate by almost two per cent against the US dollar. This decision was made in a bid to deflate the currency after a steady appreciation in its value. The Chinese central bank has since taken a whole host of measures to manage the fall in the value of the yuan. These include directing state-owned banks to restrict lending in yuan to other banks, imposing extra requirements on conversion of yuan to the dollar, and increasing the currency’s daily trading range in the domestic market.
Akin to slowly opening a dam during a flood, the interventions are meant to ensure that the decline does not turn into a currency rout. As the yuan comes closer to the psychologically sensitive level of seven yuan to the dollar — it is currently priced at around 6.9 to the dollar – market participants are smelling blood and have increased their bets on further depreciation of the currency. A self-reinforcing cycle where the central bank intervenes and draws on its reserves to manage the decline, only for its actions to be perceived as being more evidence that the currency will further depreciate, is now beginning to take shape.
The emerging turbulence in the yuan poses several challenges for Pakistan.
The result has been a continuous outflow of capital from China — net outflows reached $69.2 billion in November and have averaged close to $50bn a month since June 2016. The country has also burnt through $1tr in reserves in less than 17 months and the yuan has fallen by 6.5pc in the last year.
The pressure on the currency looks far from abating anytime soon. Rising interest rates and expectations of a fiscal stimulus under a new Trump administration in the US will weigh on the yuan. President-elect Donald Trump has consistently railed against China for purposefully undervaluing the yuan and China risks being labelled a currency manipulator by the incoming American administration. Such a move could be an opening salvo in a disastrous currency and trade war between the two largest economies in the world.
Hemorrhaging foreign exchange reserves in China and a declining yuan will surely increase geopolitical and economic uncertainty. Add to this mix the unpredictability of a Trump administration, and you have the makings of a major global economic crisis.
For countries such as Pakistan, which rely on capital inflows in the form of loans, aid and exports from both the United States and China, such an outcome is far from desirable.
The emerging turbulence in the yuan poses Pakistan with a number of challenges. For starters, a weakening yuan would make Chinese exports cheaper, leading to a further increase in Pakistan’s trade deficit, which has already widened by 22pc to $14.5bn in the first half of fiscal year 2017. This would reinforce the dependency trap that Dawn staffer Khurram Hussain so aptly described in his Jan 5 article ‘Birth of another dependency’.
Deteriorating relations between China and the United States could disrupt global trade, leading to a further collapse in Pakistan’s exports. Finally, a yuan currency crisis could also jeopardise capital inflows, particularly dollar-denominated commercial loans, from China under the China-Pakistan Economic Corridor. All of these developments would lead to a substantial weakening of Pakistan’s external finances and could threaten macroeconomic stability.
Smaller economies will have very limited options to guard against the negative consequences of a declining yuan and its second- and third-degree effects on the global economy. Pakistan’s choices, given its reliance on the largesse of the United States and China for foreign capital flows, are constrained. The persistent pressure on the yuan and its global impact can be added to the list of things that can spoil the country’s economic recovery in 2017. The cure, at least for Pakistan, lies in ultimately reforming the economy and doing away with the structural inefficiencies that only lead to tepid economic growth in fits and starts.
The writer is a South Asia analyst at Albright Stonebridge Group in Washington D.C.
Published in Dawn January 12th, 2017