In a geopolitically fractured world, one of the few things that the US, the EU and emerging and developing countries can all agree on is that China’s currency is too weak and needs to strengthen.
The news this week that China’s 2025 trade surplus reached $1.2 trillion will strengthen the already robust international consensus that China should import more and export less. A stronger renminbi won’t by itself set the Chinese economy firmly on that path, but it would certainly help.
And the Chinese authorities might be moving in that direction: the yuan (CNY – the basic unit of the renminbi) has moved below 7 to the US dollar since late last year, raising the prospect of a more meaningful appreciation of the currency in the near term.
Chatham House Director Bronwen Maddox
Yet other countries shouldn’t get their hopes up too much. China does indeed have some self-interested incentives to see its currency strengthen, primarily because a stronger currency will support Beijing’s effort to accelerate the internationalization of the renminbi.
Yet Chinese authorities face two dilemmas that will limit their willingness to tolerate a much stronger exchange rate.
The deflation dilemma
The first problem is that, while a strengthening CNY will make China’s trading partners more willing to accept the currency to settle trade transactions, it has some serious negative consequences for the domestic economy, by aggravating China’s deflation problem.
The attractiveness of the renminbi as a store of value is hobbled by the persistence of China’s capital controls and the limited role its legal system plays as a basis for international contracts. That’s why the CNY accounts for less than 2 per cent of global foreign exchange reserves. So, China’s strategy to internationalize its currency relies heavily on promoting its use as a cross-border means of exchange.
And if China wants its trading partners to accept its currency in exchange for their goods, Beijing would do well to ensure that the CNY strengthens; otherwise, receivers of it will be losing money in terms of their own currency.
Painful experience shows this is true. Between 2010 and 2014, the share of China’s trade in goods that was settled in renminbi rose very sharply, reaching a peak of 37 per cent in late 2014. As it turned out, that sharp increase in the rest of the world’s willingness to hold CNY was closely linked to the currency’s consistent strengthening during those years, making it profitable to hold renminbi balances.
But the renminbi wobbled in 2014 and 2015, and the share of China’s trade settled in renminbi collapsed: by 2017, only 10 per cent of China’s trade was being settled in its own currency. Nowadays around 30 per cent of China’s trade is settled in renminbi (according to my calculations based on official data). The fact that effectively all Russia’s trade with China is settled in CNY has given the data a boost.
Allowing the currency to strengthen further will, once again, make China’s trading partners comfortable holding renminbi. But as the CNY strengthens, Chinese imports become cheaper in local currency terms, and that entrenches China’s deflation problem.
China has had a negative inflation rate in six of the past twelve months, and a more entrenched deflationary environment could bring risks for the economy: Chinese households – whose confidence levels are already extremely low – might postpone spending if they expect prices to keep falling.
The loans dilemma
A second dilemma springs from the fact that the newest mechanism Beijing is relying on to promote the renminbi is to increase the amount of cross-border loans that it makes in its own currency.
Chinese data show that the country’s banks have been offering many more renminbi-denominated cross-border loans in recent years. The stock of those loans reached $355 billion late last year, and accounts for nearly half of all the foreign loans made by Chinese banks.
And China has also been creating offshore liabilities in renminbi by offering to convert dollar-denominated loans into its own currency. Kenya converted around $3.5 billion of dollar-denominated debt owed to China into renminbi last October, and Ethiopia is considering a similar move.
To be sure, the interest savings available from such a conversion look attractive: China’s ten-year government bond yield, at just over 1.8 per cent, is nearly 2.4 percentage points lower than that of the US.
But if the renminbi strengthens, those who are indebted in renminbi will suffer, having to fork out more dollars to buy the renminbi that they owe.