Wang Qing: An One-off 5%-10% Devaluation of Yuan Is Needed

“If Premier Li Keqiang aims at striking a bal- ance between stabilizing the financial system and holding asset prices steady while supporting the real economy， my advice to him is to allow an one-off devaluation of between 5% and 10% of the yuan， making it re-peg against the US dollar，” says Wang Qing， president and chief strategist of Shanghai Chongyang Investment Management Co.， Ltd. at a forum hosted by the Shanghai Institute of Finance and Law （SIFL）.

He explained it would avert irrational anticipation on the currency devaluation， which will eventually help stabilize expectations on asset prices.

“Regardless of the fact that both the exchange rate and the interest rate are short-run topics， we should view them from a larger and longer historical framework，” says Wang. “The above-mentioned framework for the prospect of interest rate and exchange rate is the new normal of the economy.”

Looking back to the period from 2005 to 2014 when the yuan was in a gradual appreciation， it is obvious that the irrational anticipation of the yuan appreciation was not eliminated as expected over the course.

Instead， the eight-year-long appreciation of the yuan has strengthened anticipation for the yuan’s appreciation， leading to a huge bubble in the stock market and property market with the currency in a form of external appreciation and internal depreciation.

Currently， amidst small periodical appreciation pressure and poor economic fundamentals， the monetary easing policy is making its way in China.

Given the side effects caused by the gradual appreciation of the yuan， allowing the currency depreciated by 5% to 10% will be helpful to avoid the currency depreciation anticipation and stabilize asset prices.

However， the depreciation of the yuan will affect the process of the curreny’s internationalization. In consideration of the fact that the Chinese government attaches a great impor- tance to the yuan internationalization strategy， there is limited room for the currency depreciation.

Besides， in the long run， along with the income and price levels enhancing， the yuan will come back to an upward trajectory in the future.

Internal Devaluation and External Appreciation of Yuan

On July 22， 2005， the Chinese government decided to depeg the currency from the US dollar， leading to a slight rise of 2% in the exchange rate and kick-starting an eight-year-long gradual appreciation of the yuan. In a word， over the period， China was in a monetary and financial environment featured with external appreciation and internal depreciation of the yuan.

During the period between 2004 and 2005， there was a consensus that currency was seriously undervalued， whether in both the capital market or in the international community. At that time， the International Monetary Fund （IMF） estimated the yuan against the US dollar was at least 20% undervalued， and advised the Chinese government to allow a one-off 15% appreciation of the currency before letting go.

Instead of a major one-off appreciation， China adopted a gradual way. During the period from 2005 to 2012， the ex- change rate of the yuan cumulatively rose nearly 35%. However， the gradual appreciation did not eliminate the appreciation anticipation as expected. Instead， it strengthened such anticipation.

As a result， the rapidly-expanding Chinese stock market formed a big bubble with the mania. Making matters worse， when the bubble burst in 2008 and 2009， it coincided with the outbreak of the global crisis， bringing the stock market into the rock bottom.

The 4-trillion-yuan stimulus package in 2008 brought a rebound in the stock market， but without reversing the trend towards the bubble burst. Since then， the stock market has been on a downward trajectory and did not stabilize until two years ago.

The external gradual appreciation of the yuan combined with the strong appreciation anticipation to boost the rise in the asset prices. Besides， improvements in the country’s economic fundamentals inevitably reflected in the asset prices over the past decade.

However， it needs to be emphasized that the formation of the exchange rate anticipation is an important precondition for the asset price bubble to come into being. If without the disturbance of the exchange rate anticipation， China’s asset prices would have gradually risen over the period， so would property prices.

In reality， when the currency was in a gradual appreciation， China maintained a low interest rate， as the appreciation anticipation catalyzed the hot money to flow into the country. Only by virtue of a low interest rate， China could narrowed the interest rate spread between the U.S. and China， preventing it generating more capital inflows that eventually increase the yuan appreciation pressure.

Currently， after eight years of appreciation， the currency is getting closer to equilibrium level. Basically， the currency’s periodic upward pressure has become very small， which is the background to discuss future movements of the yuan exchange rate and interest rate

Tighter Monetary Policy amid Poor Economic Fundamentals

China’s current economic fundamentals are very poor， without any shining point. From the demand perspective， momentums in investment and export growth are both weak.

The most important factor influencing the short-term fluctuations in the Chinese economy lies in the fixed asset investment. Therefore， although consumption claimed an evergrowing share， the investment in fixed assets is still the most important factor that can explain the volatilities in the shortterm economy.

At present， the growth rate of China’s fixed asset investment is slowing down. Besides， despite a rebound， the growth rate of exports is still in single digits， a far cry from the doubledigit level a few years ago.

From the perspective of investment structure， China’s manufacturing investment accounts for around 45% of the country’s total fixed asset investment. It is widely-known that the manufacturing industry is plagued by serious overcapacity in the country.

On the other side， the property investment， which makes up for 20%-30% of the total fixed asset investment， also gets sapped， with data showing that construction starts suffered a negative growth.

Interestingly， regardless of poor economic fundamentals， China adhered to a tight monetary policy over the past couple of years when the interest rate remained elevated， especially the short-term real interest rate， on backdrop of low inflation.

In addition， the exchange rate hovered at a high level， with the real effective exchange rate index keeping rising.

In November 2014， China lowered the benchmark interest rate for the first time， but leaving a big room for a further cut. Expectedly， the People’s Bank of China， China’s central bank， further cut the rate by 25 basis points.

In addition， China also cut the 7-day repo rate in the end of the second quarter of last year.

Belated Interest Cut and Depreciation

The reason behind the belated interest cut amidst the poor economic fundamentals lies in targets of the central bank’s monetary policy.

The central bank not only needs to pay attention to the short-term economic volatilities， but also take into account the rising debt and leverage ratios after 2009.

Currently， Chinese economy’s growth momentum is weak， as its two biggest engines for growth， exports and real estate，have lost power simultaneously. Besides， due to the high debt and leverage ratios， the government cannot roll out stimulus packages as before.

In such a situation， to achieve the goals of maintaining steady growth while adjusting the structure and reducing the leverage ratios， the Chinese government should ramp up exports.

Consequently， amid a sluggish global economy， the best way to inject momentum into exports is to devalue the currency. A lower exchange rate will not only stimulate exports without increasing the leverage ratio， but also help adjust the structure.

If China government allows currency devaluation to encourage exports right now， high-quality enterprises that survived over the long-drawn gradual currency appreciation will get a good opportunity to scale up， which will eventually help the transformation of China’s economy.

Therefore， in terms of the current domestic situation， the currency depreciation is a very good policy. Besides， from the perspective of the international environment， political pressures on the yuan to depreciate have waned.

So， in view of benefits of exchange rate devaluation， why is it so belated？ The only explanation is that the exchange rate is one of the Chinese government’s policy tools. The main purpose of the government is to promote the internationalization of the yuan， rather than to boost the short-term economic growth.

Appreciation Trend

In a foreseeable future， both the short-term interest rate and the medium to long-term interest rate will fall. The short-term interest rate directly depends on the central bank. According to the trend， China’s monetary policy will further ease. Therefore， the country’s shortterm interest rate will go down. However， as to how much the rate will fall， it depends on how fast the short-term interest rate will go down.

Different from the short-term interest rate， the medium to long-term interest rate is determined by market supply and demand rather than the central bank that only can influence the medium to longterm interest rate by controlling the shortterm interest rate.

Given the poor economic fundamentals， the most basic factor behind the medium to long-term interest rate lies in the return on investment for enterprises. In view of the downward trend of return on investment for enterprises， the medium to long-term interest rate will be still on a downward trajectory in the future.

Wang says， from the perspective of the exchange rate， the devaluation room for the yuan exchange rate is rather limited， as it plays an importance role in the system risk faced by the Chinese economy.

There are growing concerns about a turning point in China’s real estate market with data showed that house prices fell in the three- and four-tier cities and languished in the first- and second-tier cities.

If the house prices keep falling， the ensuing tighter credit， coupled with high debt and leverage ratios， will lead to the capital chain breakdown， then causing the real estate market bubble to burst.

In consideration of the importance of the real estate market in China， the market bubble burst will lead to the hard landing of the economy， which will be followed by capital flight.

If the yuan devaluation continues， devaluation anticipation will come into being. The exchange rate appreciation anticipation and devaluation anticipation directly affect asset prices.

Wang points out if the premier aims at striking a balance between stabilizing the financial system and holding asset prices steady while supporting the real economy， he should allow a one-off devaluation of between 5% and 10% of the yuan.

A one-off major devaluation of the currency will help export enterprises and make the currency re-peg against the US dollar， averting the yuan devaluation anticipation and stabilizing asset prices， he adds. However， he also says it will affect the internationalization of the yuan.

In the long run， the currency will appreciate. The higher a nation’s income level is， the higher the price is to be. This is a rule. If China escapes the middle-income trap and grows into a wealthier country， the country’s price level， in dollar terms， is bound to rise.