In an article last month, ‘Lies and the Sensex’ (December 22), I had pointed to the risk of market volatility arising from the Chinese yuan (or the renminbi, RMB) de-pegging from the US dollar. In our view, uncertainty around the RMB is perhaps the more important of the two key drivers of the turbulent start global markets have had this year (the other being the sharp fall in global commodity prices). Due to high foreign ownership, Indian equity markets have also been caught in the turbulence.
For any paper currency, if the relevant central bank indicates that it thinks the currency should fall, it generally does. So, in August, when the People’s Bank of China (PBoC, the Chinese central bank) decided to un-peg the RMB from the dollar and set a lower starting rate, in a clear signal to the market that it wanted the RMB to depreciate, it started to fall. The PBoC seems to have been surprised by two subsequent developments, however — the pace of capital outflows, which were perhaps much faster than it had anticipated, and the global market volatility its move triggered.
Rapid capital outflows were likely a reversal of the “hot money” flows that had accumulated in China over the previous decade as the RMB’s value against the dollar rose by nearly 3.6 per cent every year. One just had to keep money in RMB and earn 3.6 per cent a year in dollar terms. A common form of this “carry trade” was Chinese companies taking loans in dollars. The steadily appreciating RMB meant that the value of the loan in RMB terms kept falling by 3-4 per cent a year. But after the decision in August, these flows reversed, for example, as companies hurried to repay their dollar loans before the RMB fell more. What was presumed to be a gradual and small depreciation suddenly seemed to be something riskier. The problem with currencies is that, at least in the short term, the more the currency falls, the more the incentive for businesses and people to sell — one easily recalls the currency turmoil of 2013 in India.
The second factor was the inability of other countries and central banks to understand why the RMB had to fall in the first place. After all, like India, China is a beneficiary of lower commodity prices. It imports oil, iron ore, copper and coal among other things, all of which have seen prices fall sharply. As per Credit Suisse estimates, in 2015, China saw a sharp increase in its current account surplus to $294 billion as its imports fell more than its exports. Even from a market-share perspective, China already has nearly a quarter of global manufacturing. The RMB’s sudden fall was therefore perceived to be a “beggar-thy-neighbour” mercantilist move, and other central banks also let their currencies fall.
The resultant global market volatility and the sharp decline in the RMB prompted the PBoC to intervene to prevent the RMB from falling rapidly, in the process using up reserves of up to $100 bn every month. But the desired depreciation that triggered the whole episode had not been achieved. So, after two months of keeping the RMB unchanged (at a big cost to itself), the PBoC started letting the RMB fall very gradually from November onwards. This pace picked up in late-December, and the market reacted negatively again, for three reasons.
The first is the concern that, while the PBoC still has over $3 trillion of reserves, all of these may not really be available in case the depreciation of the RMB persists. What if the capital outflows exceed its ability to intervene and the RMB’s decline becomes more difficult to control? Such questions, unthinkable a year ago, are beginning to be asked.
The second is the parallel pressure seen on all other currencies. Some of this is involuntary, as in the case of Hong Kong, where the market is beginning to put pressure on its currency peg to the dollar. For many, even those not negatively affected by the precipitous decline in commodity prices, the depreciation is voluntary, driven by a concern about losing competitiveness against others. This creates problems for investors as large currency movements heighten uncertainty and make the global competitiveness of a company or an economy harder to assess. This makes it nearly impossible to value assets to an acceptable degree of accuracy, and thus buying is hard to justify. The value of their holdings also falls. At its lows last week the Nifty was down 19 per cent from the peak and back to levels seen in May 2014, but, when measured in US dollars, it was down 26 per cent, and back to March 2014 levels. Market volatility that lasts this long also affects the economy. For example, letters of credit (LCs or the guarantee letters issued by banks for cross-border transactions) become more expensive due to currency volatility.
The third concern is deflation. For economies with a large amount of debt, which means most major economies, the prospect of deflation is scary. Deflation means price levels in the economy fall, but the value of the loan remains the same, making it increasingly difficult for the borrower to honour its commitments. As China accounts for nearly a fourth of the world’s manufacturing, and assuming all the RMB’s decline is transmitted, we estimate a 6 per cent decline would push down prices globally by nearly 1.4 percentage points. This is perhaps why European Central Bank President Mario Draghi’s reassurance last week helped calm the global markets.
The RMB has held steady since the middle of January, signalling that the decline the PBoC targeted may have been completed for now. But one still does not know how much it is costing the PBoC to keep the RMB steady, or whether it could fall again later this year if inflation in China stays weak. Volatility in global markets may thus be far from over. As most foreign institutional investment in the Indian equity markets has come through emerging market or Asia funds, Indian markets may continue to be affected. The currency though seems unlikely to be at risk of a very sharp fall — with healthy FDI flows and a lower current account deficit, India should still have a balance of payments surplus. It may track other currencies down against the dollar, however.