Groundwork for Yuan Devaluation

I expect currency devaluation is the end game for nearly all countries, but the first to go will be emerging markets, not core economies since a Plaza Accord 2.0 seems impossible. The key currency for the "emerging market" complex is the Chinese yuan. Although it may be currencies such as the South Korean won that depreciate first, the yuan will eventually be the big mover that shakes the "EM" complex, followed by spillover into the euro and yen, then finally the dollar.

Before devaluing and floating the yuan, there will be much discussion in the press, such as this article. Zhang Bin of CASS has put out an opinion piece arguing a floating currency isn't to be feared, but is in fact a tool of economic stabilization.

财新:浮动汇率不可怕 是经济自动稳定器

As I've been saying here for many years, I expect China will implement a large one off devaluation that undervalues the yuan and then allow the yuan to float. Capital outflows occur because investors expect the currency will lose value. By slashing the yuan and allowing it to float, the market will bid CNY up as foreign and domestic investors repatriate funds and buy undervalued assets. Zhang Bin says much the same thing in this article.
There is a general concern that currency depreciation can lead to instability of confidence and capital outflows. This is a misunderstanding that does not distinguish between depreciation and depreciation expectations.

  Under the intervention of the monetary authorities, if the market-driven demand-driven currency depreciation is not realized or fully realized, the currency depreciation is expected to exist. The purchase of foreign currency financial assets will receive an additional expected premium, and the repayment of foreign currency liabilities will receive additional expected subsidies. Incentive capital outflows and reduced capital inflows, net capital outflows increase. This is a depreciation expectation, not a depreciation itself, driving a net outflow of capital. If sufficient depreciation is achieved in accordance with market supply and demand, in the absence of further depreciation, capital outflows have no additional expected returns, capital inflows have no additional expected subsidies, and net capital outflows are more stable.
He argues the yuan will not depreciate excessively:
Another concern about the introduction of floating exchange rates is that the RMB exchange rate under market supply and demand decisions will depreciate excessively. Based on international experience, the probability of this happening is very low.

  We define a total depreciation of more than 15% a year as a large depreciation. We have compiled large depreciation cases in the IMF database since the Bretton Woods system was disintegrated. In the nearly 40-year history, 157 large devaluations occurred in all 52 sample countries. Among the above 157 cases of large devaluation, there are high inflation or trade deficits behind the 148 major devaluations, or both. Only nine major devaluations occurred in the context of low inflation and trade surpluses.

  These nine major devaluations can be divided into several categories: 1. Exogenous economies face severe external crises: South Korea (2008-2009), Malta (1993); 2. Greatly loosening monetary conditions and actively guiding currency depreciation: Sweden (2009) Japan (2013); 3. Monetary system reform: Denmark (2000), Switzerland (997); 4. Pre-existing currency overvalued: Japan (1996) Netherlands (1997); 5. Excessive credit and excessive foreign debt: Indonesia (2001).

  These international experiences show that the foreign exchange market is not as ineffective as many people worry. China's economy is currently in a medium-to-high-speed growth, low inflation, trade surplus, no serious external economic crisis, overall controllable risks in the domestic financial system, and external debt has fallen to a lower level. From the international experience, the probability of a large depreciation of the currency in this context is very low.

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