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China’s self-inflicted woes and the renminbi

Investment Insights

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China’s self-inflicted woes and the renminbi

China’s economic growth slowed in 2021, raising doubts about the sustainability of the global recovery from Covid-19. Many observers fear the renminbi will depreciate – mirroring what often happens in struggling emerging countries. Daisy Li and GianLuigi Mandruzzato examine the outlook for China’s growth and its currency.

GianLuigi Mandruzzato
GianLuigi Mandruzzato

The Chinese economy has recently lost momentum as shown by a wide range of indicators, including retail sales, industrial production and PMI indices. In the first three quarters of 2021, Chinese GDP growth fell to an average rate of only 0.5% quarter-on-quarter. This is equivalent to 2% annualised growth, below the estimated potential growth rate of around 5.5%. It is interesting to note that Chinese GDP is returning to the trend of moderately slowing growth that has been underway for several years. 

How to interpret China’s slowdown?
 
As the Chinese economy is modernising and maturing, the service sector, which is naturally slow-growing, becomes an increasingly important share of the economy, reducing the overall growth rate. A second observation is that the intensity of the most recent slowdown raises concerns about the world economy because of the size of China. Markets often assume that the Chinese government is perfectly able to manage policy so that growth remains on a stable path. That indeed was the case until the Covid crisis. However, managing an increasingly large and complex economy was always likely to be difficult. 

The policy measures introduced recently, although leading to slower growth, have arguably put economic growth on a more sustainable path. For example, tighter regulation imposed on internet-related activities, a sector deemed strategic by the Chinese authorities, has increased uncertainty among internet operators and, unsurprisingly, contributed to the moderation in fixed asset investment. Similarly, the emphasis on reducing greenhouse gas emissions has led state owned banks to tighten the provision of finance to highly polluting sectors, curbing production as in the case of steel. 

Limited impact on the exchange rate

Faced with the slowdown in activity, many observers expect the Chinese government to facilitate a depreciation of the exchange rate to support the economy.  However, there are several reasons to believe that the Chinese authorities will not do so at the current juncture. The internationalisation of the renminbi, including the ambition for it to compete with the US dollar and the euro as a reserve currency, is a strategic objective. In addition, the domestic bond market is opening to international investors. To achieve both objectives, it is preferable for the exchange rate to remain stable.

Moreover, an opportunistic devaluation of the yuan would be frowned upon by Washington, which in the past has often complained about Beijing’s exchange rate policy. Now that the Biden administration has adopted a more conciliatory approach, the Chinese government has no interest in risking ratcheting up tensions again.

The recent decline in Chinese growth is a source of concern for investors. However, it is the result of a mix of structural and cyclical factors. The former reflect the strong economic development of the last decades and the fact that the economy is maturing: as such, this is not a reason for concern. The latter relate to government policies adopted to strengthen long-term economic and financial stability which have led to an over-reaction by economic agents: while the degree of cyclical slowdown justifies the market’s worries in the short-term, it should eventually be transitory. 

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