China Faces the Eurozone’s “Currency War”



SINCE mid 2014 the Eurozone has joined what is popularly known as “currency wars” – to use terminology made famous by Brazil’s former finance minister Guido Mantega. Between the beginning of June 2014 and the beginning of March 2015 the Euro’s exchange rate dropped by 18 percent against the US dollar. The Euro therefore followed the same path of sharp devaluation earlier pioneered among major currencies by Japan’s yen – the exchange rate of which fell by 33 percent against the dollar between November 2012 and the beginning of March 2015 under the impact of “Abenomics.” The currencies of major developing countries, such as India and Brazil, also sharply declined against the dollar in the last two years.

In assessing the impact on China of this Euro currency move it is not important whether the devaluation was a deliberate policy objective or merely a side effect of the European Central Bank’s move towards Quantitative Easing (QE). The effect is the same whether the aim was Euro devaluation or not. Eurozone exporters benefit from this devaluation while exporters to the Eurozone face greater pressure.

The resulting sharp rise in the dollar’s exchange rate, against both yen and Euro, had negative effects on U.S. exports by the end of last year. Taking a three month average, to eliminate short-term fluctuations, the year-on-year growth of U.S. goods exports fell from 4.3 percent in May 2014 to 0.7 percent in December. With such low growth rates Obama’s goal of doubling U.S. exports is out of reach.

In contrast to major devaluations of the Euro and yen, the decline in the exchange rate of China’s currency, the RMB, against the dollar has been small. Since the RMB’s all-time high against the dollar, in January 2014, China’s exchange rate has fallen slightly by under four percent.

These currency trends are shown in Figure 1, which sets them against the background of longer-term exchange rate movements since 2000.

It is important to examine the implications of this sharp Euro devaluation for China. The earlier yen devaluation had a certain limited negative impact on China’s exports – the proportion of China’s exports going to Japan fell from about eight percent at the beginning of 2012 to six percent by the beginning of 2015. But Japan is a much smaller export market for China than the European Union (EU), of which the Eurozone is the core. The EU and U.S. are China’s largest export markets – each accounting for around 16 percent of China’s exports. Europe is similarly important for China’s outward Foreign Direct Investment (FDI). The consequences of Euro devaluation are therefore potentially more significant for China than was the yen’s earlier decline.

First the trade consequences of the currency movements will be analyzed and then the consequences for capital movements – the two sharply differ.

Exports are crucial for China’s economy, as China is much more open to trade than either the U.S. or Japan – the other two of the world’s largest economies. This aids China’s efficiency, as it makes greater use of international division of labor, but means China’s economy is significantly influenced by trends in the global economy. In 2013 China’s exports were 26 percent of GDP compared to 16 percent for Japan and 14 percent for the U.S.

The most accurate way to measure the pressure of the currency movements on China is not to take bilateral comparisons but to take the “effective” exchange rates calculated by the Bank for International Settlements (BIS). These are preferable to individual bilateral rates as they are a weighted average of all the different exchange rates affecting a currency.

The low point for the U.S. dollar’s effective exchange rate this century was in July 2011. From then until January 2015, the latest BIS data, the dollar’s effective exchange rate rose 19.4 percent. In contrast the Euro’s rate fell by 3.8 percent and Japan’s by 26.5 percent. However China’s exchange rate rose 25.5 percent. Therefore while Japan and the Eurozone gained competitive advantage, China’s currency rose not only against those currencies but even against a strong dollar.

These trends are even sharper when measured by the BIS’s “real” effective exchange rates – i.e. taking into account inflation in different economies. From July 2011 to January 2015 the dollar’s real effective exchange rate rose by 15.5 percent. In contrast the Euro fell by 8.1 percent and the yen by 29.1 percent. China’s rate rose by 27.8 percent. So in real terms the devaluation of the Euro and yen against the RMB and the dollar was even greater than indicated by market exchange rates.

Given major exchange rate pressure on China it is a sign of the competitiveness of China’s export sector that its performance has been rather strong – weakness in imports, not exports, has been the primary problem in meeting China’s trade targets in the last period.

To show the trend in China’s exports, taking December figures (to avoid calculation difficulties caused by China’s lunar New Year falling in different months in different years), and a three month average, to remove short-term fluctuations, China’s exports were up 8.5 percent year-on-year in December 2014. This is a strong performance in current weak global conditions – in particular in contrast with the U.S.’s 0.7 percent export growth.

But China’s continued relatively strong export performance is achieved by big long-term shifts in its pattern. The effect of slow growth in developed economies, now worsened by devaluations in the Eurozone and Japan, means these markets account for a decreasing proportion of China’s exports. Defining advanced economies as North America, Europe, Japan plus Australasia, the percentage of China’s exports going to such economies fell from approximately 65 percent in 2000, to 49 percent by the end of 2011, then to 44 percent by the end of 2014. This trend is shown in Figure 2.

China is being transformed from a supplier of exports to advanced economies to a trade dynamo for developing economies – whose trade grows much more rapidly than developed economies. This shows why China pays such attention to the BRICS economies, with initiatives such as the BRICS Development Bank, to the creation of the Asian Infrastructure Investment Bank, and to the Belt and Road Initiatives. The sharp devaluation of the Euro, as earlier of the yen, will strengthen this trend, and meeting China’s 2015 target for a six percent expansion in trade will be heavily reliant on trends outside Europe and Japan.

Turning to the effect on capital movements of these currency shifts, a distinction must be made between short-term trends and the fundamental pattern of China’s long-term FDI.

Present short-term shifts in capital flows undoubtedly create significant problems for China. For those engaged in short-term speculation, or who see their interests primarily in currencies other than the RMB, even the four percent fall in the exchange rate of the RMB against the dollar is a significant shift. Therefore, short-term capital movements out of China began late in 2014. By draining funds and liquidity from China this places downward pressure on its economy. Countering this downward pressure is one reason China’s central bank recently cut interest rates and relaxed bank reserve requirements. Such capital outflows are detrimental to China and an illustration of why liberalization of its capital account would have dangerous consequences.

But for China’s long-term FDI the strengthening of the RMB against the Euro is advantageous as it lowers the price in RMB of assets purchased in Euros. FDI is also driven by more long-term structural features than short-term capital flows or even trade.

Due to the small size of Japan’s economy, compared to the U.S. or EU, and to political tensions, Japan is not a key target for China’s outward FDI and therefore yen devaluation is unlikely to produce strong effects in stimulating China’s FDI by investment in Japan. But the Euro is different – the EU is a key target for China’s overall FDI expansion.

As recently as 2010, the total stock of China’s FDI in the EU was less than US $5 billion. By the end of 2012, Chinese investment stock had quadrupled to US $21 billion, according to Deutsche Bank figures. By 2014 the annual flow of China’s FDI into Europe was US $18 billion according to data from Rhodium.

The background to this is the rapid overall growth of China’s outward FDI. The average annual rate of increase of outward world FDI from 2000 to 2013, according to the latest available data, was only one percent. There was a nine percent average annual increase by developing economies and a two percent annual average contraction by advanced economies. But China’s average annual increase in FDI was 44 percent. China’s rapid build-up is shown in Figure 3.

But China is only at the beginning of FDI expansion. China’s outward FDI in 2013, the latest year for comparative UN data, was US $101 billion – below Japan’s US $136 billion and the U.S.’s US $338 billion. Given China’s formidable financial firepower, with the world’s largest domestic savings, acceleration of China’s FDI will increase. China speeded up investments in Europe during the Eurozone debt crisis, which made European assets cheaper, and their price in RMB has again fallen with Euro devaluation.

The recent sharp Euro devaluation, following that of the yen, will therefore speed up diversification of China’s exports away from advanced economies, and is accompanied by difficult trends in short-term capital movements, but it will not halt China’s rapid build-up of outward FDI.