Double-Edged Sword

By+Wang+Jun

Finally the European Central Bank （ECB） decided to follow the decision of Federal Reserve （Fed） to print money massively. It is uncertain whether the eurozone can brace powerful recovery， just as the United States did after quantitative easing （QE）， but far away in China， the yuan has been affected.

Mario Draghi， President of the ECB， announced on January 22 that the ECB would launch an expanded asset purchase program. Under this program， the combined monthly purchases of public and private sector securities will amount to 60 billion euros （$68 billion）. The program will most likely be in effect until the end of September 2016 and will in any case be conducted until the inflation rate is close to 2 percent over the medium term. This means that， altogether， there will be nearly 1 trillion euros （$1.13 trillion） in the market.

The euro fell sharply after the ECB unveiled such a big QE program， falling to an 11-year low of $1.13 on January 22. Driven up by the eurozones QE， the central parity rate of the yuan strengthened by 1，409 basis points to 6.9795 against the euro on January 23， the biggest daily rise since November 2011 and lower than 7 yuan for the first time in history， according to figures from the China Foreign Exchange Trading System.

The launch of QE by the ECB， together with the U.S. normalizing its monetary policy， will lead to a stronger U.S. dollar， which may impose downward pressure on the exchange rate of the yuan against the U.S. dollar， said Pan Gongsheng， Vice Governor of the Peoples Bank of China （PBC）， the countrys central bank， at a press conference held by the State Council Information Office on January 23.

Yuan under pressure

According to a report by Minsheng Securities Co. Ltd.， accelerated QE by central banks of Europe and Japan will further depress the ex- change rates of the euro and Japanese yen； with strong economic recovery and weakened easing measure by the Fed， the U.S. dollar will become stronger.

After the launch of QE by the ECB， the yuans central parity rate weakened by 95 basis points to 6.1342 against the U.S. dollar on January 23， according to the China Foreign Exchange Trading System. The yuans rate against the U.S. dollar continued to slump for a second trading day on January 26， hitting the lowest level since June 2014.

The yuan faces depreciation pressure against the U.S. dollar， but with intervention from the PBC， the depreciation wont be too significant. Further， the yuan exchange rate against the U.S. dollar may have twoway fluctuations. In the meantime， since the yuan is unofficially pegged to the U.S. dollar， it will accelerate appreciation against other currencies.

“The European version of QE will bring more capital to China， while the expected rate hike in the United States may bring depreciation pressure to the yuan，” said Deng Haiqing， chief analyst of CITIC Securities Co. Ltd.， when interviewed by National Business Daily. “Under various pressures， it is still uncertain if the yuan will appreciate or depreciate.”

According to Deng， the depreciation of the euro and the appreciation of the U.S. dollar will both affect yuans exchange rate， and it is still uncertain the yuan will appreciate or depreciate.

Since the PBC announced an interest rate cut on November 21， 2014， the yuan has depreciated rapidly. The PBC figures showed that in December 2014， the funds outstanding for foreign exchanges fell by 128.91 billion yuan （$21 billion） from the previous month， the biggest monthly fall since December 2003. Deng said the sharp fall of funds outstanding for foreign exchanges may be due to the PBCs intervention to alleviate the yuans depreciation pressure.

“Judging from this， the Chinese central bank is reluctant to see the depreciation of the yuan，” he said， adding that the yuans depreciation may impede the process of developing the Shanghai free trade zone and making the yuan an international currency. It is not logical that China tries to spur exports by depreciating its currency.

A report on the Economic Information Daily said that the European QE could intensify the competitive depreciation of global currencies. The yuan will also face more depreciation pressure， but the depreciation wont be significant， and it may appreciate against other currencies.

Lu Zhengwei， chief economist of Industrial Bank Co. Ltd.， holds different views. According to him， the effective exchange rate of the yuan is not at an equilibrium level now， and it has long been overrated. This is also the basic reason why the Chinese economy has not been able to recover as quickly as expected. If the overrating can be modified—through yuans depreciation—China will easily resume economic growth above 7.5 percent. Lu has a bold estimation that the yuan will depreciate as much as 5 percent this year.

Impact on China

Since the scale of this round of QE is much bigger than expected， the euro is likely to continue depreciating in the short term， strengthening the U.S. dollar. As the yuan is unofficially pegged to the U.S. dollar， appreciation of the U.S. dollar will also push up the yuans exchange rate against other currencies， imposing pressure on Chinas exports.

In the long term， however， economic recovery in the eurozone will increase Chinas exports. In 2014， the EU remained Chinas largest trading partner. Trade volume be- tween China and the EU amounted to $615 billion in 2014， up 9.9 percent， according to data from the General Administration of Customs. Among the total， Chinas exports to the EU totaled $371 billion and its imports from the EU totaled $244 billion， up 9.4 percent and 10.7 percent， respectively.

“The program will help boost the eurozones economy， increase demand and potentially boost Chinas exports， because Europe is one of Chinas most important trading partners，” Pan said at the conference.

The European QE is likely to further boost investors confidence and devalue the euro. Devaluation of the euro and decline of oil prices will intensify the pressure of imported deflation in China.

To address the possible risks of deflation and the pressure on economic growth， the PBC may further relax its monetary policy， predicted the Economic Information Daily report. It is expected that the Chinese Government will adopt relaxed or diversified monetary policy tools to ensure stable economic growth.

Meanwhile， the eurozones QE will further undermine the euros position as the worlds second largest reserve currency. On the other hand， thanks to the yuans stable exchange rate， Chinas high growth speed and large economic scale， its currency is expected to be accepted by more international investors.

The ECBs bond-buying plan will release a huge amount of liquidity， which will weaken the euro and force capitals to flow out and return to the United States. “The large liquidity brought forth by the new round of QE in the eurozone will no doubt cause a spillover effect， and the strengthening of the U.S. dollars exchange rate will drive capital back to the United States. All this will increase the uncertainty of the international capital flow，”said Pan. The Economic Information Daily report said that China may also receive some of these capitals.

When the yuans use as a global currency increases， the euronzones QE is likely to bring new opportunities for the internationalization of the yuan.