Aug. 28, 2016 1:15 p.m. ET
The calm in China’s currency is making some investors uneasy.
Twice in the past year, sudden drops in the value of the yuan have rattled global markets, sparking concerns that a deeper decline was at hand as officials struggle to orchestrate an economic “soft landing” following years of debt-fueled growth.
Since then, the People’s Bank of China has calmed the waters by improving communications and the government has increased stimulus in a bid to stabilize growth. The Federal Reserve’s decision to delay rate increases has kept a lid on the value of the U.S. dollar, relieving some of the pressure on the yuan.
Yet in a refrain familiar by now to investors the world over, analysts are worrying that stimulus alone won’t be enough to get China’s growth back on track and support the yuan indefinitely. Fundamental indicators of Chinese economic health continue to deteriorate, a sign to skeptics that the currency remains overvalued and a reminder of the challenges facing the world’s second-largest economy.
“China has done a good job in anchoring market expectations and using all the tools in its policy toolbox to stabilize the economy, but it hasn’t fixed the underlying problems,” said David Loevinger, a managing director at TCW Group, which has $194.6 billion of assets under management.
Since its devaluation in August 2015, the yuan has depreciated 6.9% against the dollar, less than the British pound and the Mexican peso. After losing about $800 billion of its foreign reserves, China has managed recently to slow capital flight.
But the stability came “at the cost of delaying reforms,” said Hung Tran, executive managing director at the Institute of International Finance. To sustain growth, China has postponed overhauls of its state-owned enterprises, many of which are plagued by overcapacity and bad debt.
Private fixed-asset investment in June and July registered back-to-back monthly declines from year-earlier levels, the first time that happened since at least 2012.
It’s “a sign of business confidence falling, and people worry that adding more credit is no longer efficient,” said Claire Dissaux, an economist with Millennium Global Investments Ltd.
The retreat reflects in part the costs of China’s rapid debt buildup since the financial crisis.
The country’s total debt has climbed to 298% of its gross domestic product from 274% a year ago, according to the IIF. Rapidly rising debt tends to be associated with slowing growth, as risks of capital misallocation and default increase.
Signs abound that consumers and businesses are bracing for further devaluation. Some Chinese exporters have been hoarding dollars and keeping their earnings overseas, a move that analysts say could limit foreign-currency inflows and leave banks short of funds to lend out.
Outside the country, investors are hesitant to sink money into Chinese bonds and other yuan-denominated assets despite the government’s efforts to lure foreign capital. Chinese government bonds boast much higher yields than their Western counterparts.
“Depreciation remains a big worry for a lot of people,” said Larry Hu, China economist at Macquarie Securities, a Sydney-based investment bank.
In recent months, China’s exchange-rate maneuvering has largely been driven by the dollar. When the greenback is weak, the PBOC anchors the yuan to the dollar and lets it fall against a broader group of currencies that includes the euro and the yen as well as the dollar.
Conversely, when the dollar advances, the central bank lets the yuan weaken against it while keeping it largely stable against the basket. This year, the dollar has weakened for longer than it has strengthened, resulting in a weaker yuan versus the basket than versus the dollar.
Many within China believe the yuan should be allowed to fall further as the country’s economy slows, but the central bank has had to take care that such weakening is gradual enough that it doesn’t speed up capital outflows.
Already, there are signs that outflows are accelerating again amid recent yuan weakening, after having slowed earlier this year. A net $55 billion left China in July, according toGoldman Sachs Group Inc., compared with an estimated $49 billion the previous month.
Beijing’s challenge is how to continue letting some air out of the yuan without triggering excessive outflows and market instability.
Ms. Dissaux of Millennium Global said she believes the market is underestimating the risk of yuan depreciation against the dollar. Investors in the yuan forwards market now expect the yuan to weaken by 2% over the next 12 months, down from 7% earlier in the year.
Strategists at Bank of America Merrill Lynch said in a recent note that the yuan remains vulnerable to renewed capital flight.
Yet even skeptics agree the timing of any market shift remains hard to predict.
“The Chinese will do everything in [their] power to maintain domestic and external stability” in the lead-up to the G-20 summit in early September and the yuan’s accession into the International Monetary Fund’s official basket of reserve currencies in October, said Eswar Prasad, a former top China hand at the IMF. “It’s unlikely for China itself to be a source of instability at least for the next three to four months.”
The real test will come for China’s yuan and its exchange-rate policy when the market starts to price in more aggressive Fed rate increases and the dollar resumes its upward march, investors say.
Senior Chinese officials have repeatedly pledged to keep the yuan largely stable and not to engage in beggar-thy-neighbor devaluations—a statement many say likely will get repeated next month when leaders from the Group of 20 nations meet in the eastern Chinese city of Hangzhou for a summit.
“In theory, [yuan] depreciation should benefit exports,” a senior Chinese official said. “But it’s not a good idea,” in part because the government has pledged to rebalance the economy away from export industries and toward consumer-facing businesses.
Any shift in investors’ stance toward China is likely to be deeply felt in financial markets. In a new report, “What Might Disrupt the ‘China Calm,’ ” UBS Group AG analysts said greater depreciation pressure on the yuan “may lead to higher global investor risk aversion.”
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