| The exchange rate of the yuan against the U.S. dollar has been depreciating since January. This is the biggest depreciation since China's exchange rate reform in 2005. What are the reasons for this round of yuan devaluation? How long can it continue? And how will the yuan exchange rate fluctuate in the future?
To answer these questions, one must conduct a comprehensive analysis on the supply and demand of the U.S. dollar and the yuan, which decides the trend of the yuan's exchange rate. In general, the main factors affecting the supply and demand of foreign exchange include economic growth, balance of international payments, interest rates, monetary policy, the inflation rate, liquidity and flow of hot money.
The higher the economic growth rate is, the more domestic currency a country will need, and the more foreign currencies will flow in. This will lead to appreciation of the domestic currency and depreciation of foreign currencies. Although China's economic growth slowed down to 7.4 percent in the first quarter, it's still much higher than the U.S. GDP growth, which was 1.9 percent in 2013. In January, the IMF forecast that the U.S. GDP may go up 2.8 percent this year, while China's GDP may grow 7.5 percent.
Balance of international payments can accurately reflect the supply and demand of foreign currencies. If surplus exists in China's current account and the capital account, it means there is demand for the yuan, which will lead to its appreciation. In the first quarter, although the growth of trade volume slowed down, China still had a trade surplus of $16.74 billion. The current account surplus reached $7.2 billion, the capital account surplus was $118.3 billion and its reserve assets increased by $125.5 billion. Foreign currencies have continued flowing into China through the current and capital accounts.
The higher the interest rate is, the higher interest income will be gained for capital. This will attract an inflow of capital and the yuan will appreciate. If the interest rate drops, capital will flow out and the U.S. dollar will appreciate. On April 25, the London Interbank Offered Rate (Libor) stood at 0.09 percent, the U.S. federal funds rate was 0.25 percent, the Shanghai Interbank Offered Rate (Shibor) was 2.31 percent and China's benchmark interest rate for one-year deposits was 3 percent. China's interest rate level is much higher than that of the United States.
Monetary policy is also an important factor affecting the exchange rate. A relaxed monetary policy will weaken the domestic currency, and foreign currencies will appreciate. China's prudent monetary policy has not substantially changed. Although the U.S. quantitative easing (QE) may be phased out by the end of this year, the first interest rate hike will be in the range of mid- to late-2015. Therefore, the U.S. monetary policy is still relaxed. The tapering of QE is not an important factor in the yuan's recent devaluation.
The higher the inflation rate is, the lower the real interest rate will be, which will cause outflow of capital and the exchange rate of the domestic currency to drop. The inflation rates in both China and the United States have not changed remarkably compared with 2013, so changes in the inflation rate are not a major reason for the fluctuation of the yuan exchange rate in 2014.
The stronger the liquidity in the monetary market, the more adequate the supply of domestic currency will be; hence, the domestic currency will weaken. In the January-March period, Shibor declined remarkably while the interest rate in the United States did not change significantly and --Libor remained at a low level.
Inflow of hot money will increase the demand for yuan, and the yuan will then consequently become strong. Many scholars attribute the reason for this round of yuan depreciation to the tapering of QE, which causes a flow of hot money out of China. However, I don't think hot money outflow is a major reason. Hot money must enter China through the current and capital accounts, both of which had surpluses in the first quarter.
From the above analysis, we can clearly see that liquidity is the sole reason for the recent devaluation of the yuan. The increase in liquidity has offset the increase in the demand for the yuan brought by capital inflow. China's economic slowdown has reduced the demand for money supply, thus leading to loose liquidity in the market.
Now, we approach the question of how long the current devaluation of the yuan will maintain. A basic judgment is that the factors required for the yuan to appreciate have not changed: China's economic growth is above 7 percent, the interest rate level is higher than the United States, the current account and capital account both maintain surpluses, foreign exchange reserves are increasing, and the U.S. dollar capital keeps flowing into China. Therefore devaluation of the yuan is temporary, and relaxed liquidity will not stop the yuan from appreciating.
The future trend of the yuan exchange rate will be decided by China's economic growth and monetary policy in the second and third quarters. If the growth rate picks up and liquidity is tightened, yuan depreciation will be expected to end soon. From the data of daily coal consumption, it is unlikely that the economic growth will recover in April, so the yuan may further devaluate in April and May. But with strengthened fiscal policy, the growth rate is likely to rise again at the end of the second quarter, when the yuan exchange rate will begin to rise again.
This is an edited excerpt of an article by Wang Yupeng, a macroeconomic researcher with the Beijing-based CFFEX Institute for Financial Derivatives, published in Securities Times | 
