A YEAR ago, many hedge funds were congratulating themselves on one of their better ideas: borrowing cheap yen and investing in long positions on the Chinese renminbi.

The trade was both safe and lucrative. The two currencies are among the most controlled in the world. The Japanese government, with the strong support of the Bank of Japan, was doing everything it could to drive down the value of its currency. Meanwhile, the Chinese government had allowed its currency to steadily appreciate — about 35pc in trade-weighted terms since 2005.

A slowly rising renminbi was part of Beijing’s policy to force manufacturers to move up the value-added chain. It was also part of a policy to internationalise use of the renminbi, especially between Chinese exporters and overseas customers. And while capital controls remain, the goal of that internationalisation is for the renminbi to eventually become a reserve currency alongside the dollar.

A healthier domestic market will make possible new sources of growth, which will put China on a more competitive trajectory

A year later, much has changed in the volatile currency world. The Indonesian rupiah recently fell to a 16-year low against the dollar. Brazil and Russia too have seen the value of the real and the rouble crash. The currencies of India and Turkey, two big beneficiaries of lower oil prices, were originally buoyed by that development but they too are moving down against the once-again mighty greenback. South Korea has cut rates twice since August in an effort to keep its currency from rising too much against the yen.

Analysts expected China to similarly drive down the value of the renminbi. In the spring, when the Chinese allowed or encouraged (depending on how controlled you believe the currency to be) the currency to fall about 3pc, that view seemed right. Statements from the State Administration of Foreign Exchange suggested, though, the move was inspired by the desire for two-way volatility ‘in accordance with market principles’ at a time when the renminbi was regarded precisely as the hedge funds had it: a safe one-way bet. Today, “the [renminbi] stands as a bastion of relative strength in the emerging market forex world,” analysts at Goldman Sachs wrote in recent research. That policy remains in place — though at the moment, this stance appears to be counterintuitive.

China recently cut interest rates precisely because its economy is slowing. The real burden of debt is becoming heavier as inflation falls. Producer prices have been in deflationary territory for 32 months and counting. Goldman concedes the odds of a softening currency may be building. “The strength in trade-weighted terms is conspicuous, given a backdrop of weak growth, low inflation and depreciating currencies in the neighbourhood — especially the outsize move in the yen,” the report notes. “Markets also appear to be sniffing out some weakness with onshore spot drifting toward the weak end of the trading band.”

Still, while China is slowing, it is slowing off a much larger base. As its population ages, it can begin to discard its previous low value-added, export-driven growth model, fuelled in part by huge economies of scale and a cheap renminbi. Moreover, slower growth does not mean lower-quality growth but the opposite. China is moving toward a domestically driven model and away from its investment-heavy, resource- — (and pollution) — intensive template. Recently, for the first time, consumption contributed more to growth than investment. As part of that move, China is allowing wages to rise.

A healthier domestic market will make possible new sources of growth, which will put China on a more competitive trajectory. Cheap physical capital and impressive human capital will spawn innovation and may even serve to reinvigorate manufacturing at the high end. Data-mining, robotics and 3D printing are today the province of the developed world. China will challenge that monopoly. Already the scale of China’s mobile internet industry has allowed it not only to leapfrog India but overtake the US in some areas.

Meanwhile, Japan’s cheap yen means its manufacturers are under less pressure to change and move away from the template they have embraced since the war, using a captive domestic market to support overseas sales. By contrast, China no longer needs to rely quite as much on a cheap currency to support its path to prosperity.

henny.sender@ft.com

Published in Dawn, Economic & Business, January 6th, 2015

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