Low growth in China and its effect on the exchange rate

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Question: 

Can you please explain the mechanics behind this statement from deutsche bank regarding potential market risks for 2019: "slowing growth in China may trigger substantial US dollar appreciation". Is this essentially saying that since growth will slow in china, American imports will increase and thus the demand for USD will increase causing the currency to appreciate?

Answer: 

Fundamentally the change of the exchange rate reflects the difference of productivity growth between China and U.S.. In the past decade, the productivity of China grew faster than U.S. and therefore we see a long-term appreciation of RMB over U.S. Dollar. The trend seems reversed in 2018.  In the 4th quarter of 2018, the growth rate in China is 6.6%, which is almost the lowest since early 1990s. In contrast, U.S. economy is pretty strong now. 

In the short run, you are right that the demand and supply of U.S. dollar (in term of RMB) determines the exchange rate. There is a currency exchange market located in Shanghai. The demand and supply of currency arise from capital investment and export/import of goods. 

When China slows down, the return of capital investment in China would low, which implies more capital will flow to U.S.. Therefore firms would like to exchange RMB for U.S. dollars to make investment in U.S. (or reduce investment in China)  leading to strong demand for U.S. dollars. Moreover, when the economy slows down, the central bank of China may implement more relaxed monetary policy which would depress the interest rate and thus further increase the demand for U.S. dollar.  The strong demand of U.S. dollars (due to capital flow) would cause appreciation of U.S. dollar over RMB. 

On the other hand, when China's economy slows down,  China's demand for imports would be weak, which would result in weak demand for U.S. dollars and therefore depreciate U.S. dollar.

From the above discussion, we can see there are two countervailing effects. However since generally the effect of capital flow dominates the effect of import/export, we would see the appreciation of U.S. dollar when China's economy slows down. 

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Last updated on January 25, 2019