Chinese currency could hurt the rest of the world

The Chinese currency will weaken and this will hurt the international economy, economist Andrew Smithers said in a recent report on the second biggest economy in the world.

Recent data on China has pointed to renewed weakness. The pace of growth of its industrial production fell from 10% in the fourth quarter of 2013 to 8.6% in the first two months of this year, well below consensus expectations of a 9.5% increase.

Investment growth also decelerated, to 17.9% in the first two months of this year from 18.2% in the fourth quarter, due to a slowdown in credit, RBS economist Louis Kuijs noted.

Retail sales grew by 11.8% over the period, slower than expectations of 13.5% and compared with December’s 13.6% increase.

Based on this data, analysts at Bank of America Merrill Lynch cut their forecast for economic growth to 7.3% from 8% for China for the first quarter of this year and to 7.2% from 7.6% for the whole year.

Smithers said that China will need to promote a “more volatile” exchange rate to allow inflation to rise and thus mitigate the risks that bankruptcies – caused by excess credit and a slowdown in economic activity – would increase too quickly.

Generally, when inflation rises fewer companies go bust because their debt becomes smaller in real terms; they can also raise prices more easily to bring in more revenues.

Chinese Currency Role

The Chinese currency, the renminbi, has been appreciating steadily over the past few years, after China was accused by the US and other big economies of manipulating its exchange rate to become more competitive on international markets.

This week, a Chinese solar power company defaulted on payments of a corporate bond. It was the first time the government has not intervened to stop a corporate bond default, prompting analysts to predict that more defaults are likely.

While some borrowers “need to be allowed to fail in order to curb the growth of the carry trade,” according to Smithers, the government is facing the difficult task of ensuring that the bankruptcies do not spark contagion in China’s wider financial system. One way of doing that is to boost inflation, which currently lingers at around 2%.

“It seems to us likely and desirable that inflation will pick up and the nominal exchange rate will become more volatile in the short-term, with a flat to falling trend over the next year or so,” said Smithers.

This in turn will help Chinese exports, which would end up crowding out sales from other countries, with a negative impact on global output, he warned.

Smithers has calculated that an improvement equivalent to two percentage points of gross domestic product in China’s net exports in one year would lower output growth in the rest of the world by up to 0.67% of GDP, “roughly double the impact that such a change would have had a decade ago.”

Unlike other currencies, the Chinese currency is not traded freely on the global markets, so the Chinese central bank has an easier task if it wants to control the direction of the exchange rate.