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Foreign Exchange

Five Lessons From the RMB Fallout

What China’s currency devaluation can teach us about currency risk management in emerging markets.
Kok-Chi Tsim, Managing Director, International Banking, J.P. Morgan
May 9, 2016

In August 2015, the People’s Bank of China (PBoC) unexpectedly depreciated the renminbi (RMB). Thereafter, the value of the RMB dropped by over 6 percent against the US dollar (USD) before recovering, which caught many foreign businesses operating in China off guard. Assuming that the RMB was immune to market volatility, they failed to appropriately manage the risk of devaluation—and thus were left overexposed. The USD value of their investments in China fell sharply, and businesses that had financed their Chinese operations with USD-denominated loans faced worsening repayment terms. And although it may be too late for most of these companies to recoup their losses, the RMB’s devaluation holds important lessons in managing currency risks for companies doing business in emerging markets like China.

From Confident to Complacent

Over the last decade, the Chinese economy has thrived. From 2002 to 2011, China’s annual GDP growth rate didn't drop below 9.1 percent, and for six of those 10 years, growth rates reached double digits. Along with the strength of the Chinese economy, the value of the RMB also appreciated considerably, from 8.277 per USD in 2002 to a high of 6.044 in early 2014. 

Unlike most currencies in developed economies, the RMB does not fluctuate freely on the global exchange market. Instead, the PBoC pegs the RMB’s value to the USD and smooths its movements. Historically, this strategy has reduced market volatility and encouraged direct foreign investment in the Chinese economy.

No economy can grow without restraint forever.

Unfortunately, as we’ve learned from both history and international economics, no economy can grow without restraint forever. While the RMB’s shift stunned many companies and left them scrambling to cover their positions, it ultimately should not have been surprising.

Since 2011, the Chinese economy has been undergoing a structural transition as the nation matures from a manufacturing powerhouse into a service- and consumer-driven economy. This transformation has led to a slowdown in the Chinese economy, with annual GDP growth rates falling below 8 percent for the past few years. This in turn has led to pressure on the RMB to depreciate, particularly against the USD, which has strengthened against most other currencies.

As mentioned above, the Chinese government, like most governments of emerging economies, tries to manage changes in its currency’s exchange rate. However, there comes a point where economic and market pressures on currency movements become too great—this is when change happens, often with dramatic effects.

This is what happened in August of 2015—capital outflows surged when the RMB unexpectedly devalued. In the aftermath of the devaluation, many companies found themselves fighting against the same measures that had once kept the RMB stable. After allowing the currency to fall, the PBoC took strong measures to smooth out the decline, prevent further capital flight and lessen the influence on market participants. These measures—including more stringent restrictions on purchasing and remitting large amounts of foreign currency—have prevented companies that are exposed to the RMB from covering their positions. Companies with large RMB cash holdings in China are therefore vulnerable to further depreciation. The government has also clamped down on early repayment of cross-border foreign currency intercompany loans, leaving companies that have used USD loans to finance their Chinese operations exposed to further RMB depreciation. 

FX Fundamentals

These events in China have reminded businesses operating in China of a couple of fundamental principles of currency risk management:

  • Borrowing in USD to finance Chinese operations holds long-term currency risks. When the RMB was appreciating, borrowing in USD outside of China to finance operations in China through intercompany loans seemed like an attractive proposition—the Chinese operation would need to earn relatively fewer RMB to repay the loan. However, devaluation has reversed that relationship—now businesses need an increasing amount of RMB to make payments in USD. And since Chinese regulators now discourage the early repayment of cross-border foreign currency loans, the potential for further devaluation compounds the currency risks. What happened in China is an affirmation of the basic risk management principle of borrowing in the currency—in this case, in RMB—of your future cash flow.
  • Holding more RMB in cash than necessary exposes companies in China to currency risk. While there are a number of legitimate reasons for companies in China to hold on to extra RMB in cash (e.g., for planned future investments), many decided to hold extra RMB balances to take advantage of the currency’s appreciation and higher interest rates. This strategy has obviously backfired now that the RMB has depreciated. Furthermore, the controls over large foreign currency purchases and remittances mean that it will likely be more difficult to get those extra RMB out of China, which only compounds the problem.

Five Lessons From RMB Devaluation

In addition to reminding businesses about currency risk management principles, the recent depreciation of the RMB also teaches some broad lessons about doing business in emerging markets like China.

  1. Nothing lasts forever. Since 2005, the RMB has appreciated steadily, which created a false sense of stability for companies operating in China. However, the global economy moves in cycles, and the PBoC’s ability to control volatility in the past was no guarantee that it would be able to contain the currency’s weakness in the future. Predicting the market’s timing is nearly impossible, which means it’s important to manage risk before problems occur. For example, though it was advantageous to keep cash reserves in China while the RMB was appreciating, currency controls have made repatriation difficult now that the RMB has depreciated. Only companies that hedged their exposure to currency risks before conditions turned unfavorable were able to limit their losses.
  1. Watch for signs of stress in the currency markets. The Chinese economy began showing signs of a slowdown in 2012 when China embarked on its transition from a manufacturing- and export-driven economy to one more reliant on service and private consumption. This should have been one sign that the long period of RMB appreciation could come to an end.
  1. External forces matter. Not only were economic conditions pushing the RMB lower, but external pressure also played a role in forcing the devaluation. China’s bid to place the RMB among the IMF’s reserve currencies created an incentive to allow the currency to move more freely on the global market. At the same time, the US Federal Reserve’s imminent interest rate hike caused the USD’s value to climb, which in turn caused the RMB to become increasingly overvalued throughout the summer of 2015.
  1. Market forces always prevail. Although the Chinese government attempted to manage the movement of the RMB foreign exchange rate, it could not ignore economic and market forces. Businesses should therefore not become complacent about the ability of the Chinese government to maintain a stable foreign exchange rate.
  1. Emerging markets are inherently volatile. Even an economy as large as China’s is prone to sudden reversals. Rapidly growing economies in the developing world may present extraordinary opportunities for foreign investment, but their economic and financial infrastructures are often not fully developed, which can lead to unexpected shocks and crisis. Companies investing in emerging markets need to be prepared and be able to manage through such volatility.

The Long Run

Ultimately, the Chinese economy may still hold tremendous growth potential. China may have missed its growth target in 2015, but if it's successful in transitioning to a service- and consumer-driven economy, the nation may well have decades of high-quality growth ahead of it. In particular, it will likely benefit US companies in the consumer markets and service industries.

[China] may well have decades of high-quality growth ahead of it.

However, this growth potential will continue to bring risks with it, especially in the currency markets. The Chinese government’s ability to stabilize exchange rates has already been tested, and the growing dynamism of the Chinese economy will likely limit the government’s ability to contain the impact of economic and market forces on the RMB foreign exchange rate in the future.

Ultimately, the most important takeaway when doing business in emerging markets like China is that the risks should be properly managed. Businesses should continue to exercise caution and make sure they’re continually revaluating their foreign exchange strategies and policies—because managing currency risk is an increasingly important element of successfully operating in emerging markets across the globe.

 

 

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