Much Ado About Yuan

Friday, August 14, 2015 13:13
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Much Ado About Yuan

China began to devalue their currency and markets reacted sharply.  As the week progressed, however, initial fears proved to be unfounded. 

 

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What Happened?   China Begins to Devalue Their Currency

yOn Tuesday, the People’s Bank of China altered the trading range of the Chinese yuan allowing it to depreciate modestly.   The exchange rate of the yuan does not move freely and is permitted to trade only within a narrow band around the U.S. dollar.  The PBOC “fixes” the trading range of the yuan everyday and ensures it trades within it.  With the dollar’s ongoing appreciation against other currencies, the yuan had also strengthened over the year.  

 
Markets Reacted Sharply But Initial Fears Were Calmed
The PBOC move was not widely anticipated and initially caught markets by surprise.  There was much speculation around how fast and how far the yuan would be permitted to fall.  Anxiety around the PBOC’s uncertain intent sparked talk of currency wars and global deflation by doomsayers and media outlets.  Some market analysts even anticipated competitive counter devaluations by other central banks.   Equities and currencies around the world sold off on the news and the price of gold rallied on the back of these new fears.  However, as the week progressed these initial anxieties proved to be unfounded.  
 
Over four trading days the Chinese yuan depreciated by less than 5% - a modest and orderly decline by any standard.  Importantly, Chinese authorities stepped in at the end of the first few trading sessions to firm up the yuan.   Also, on Friday the yuan trading range was set so the Chinese currency actually appreciated slightly.  These are strong indications the PBOC is seeking a gradual devaluation on their terms and would not stand by idly if markets got too far ahead of the pace they had in mind.  Furthermore, the PBOC took an unprecedented step to ensure clear communication of this intent by holding a press conference on Thursday.  The PBOC indicated they were seeking only a short-term adjustment and that there was no basis for a sustained decline in the yuan.
 
Why Did Chinese Authorities Move to Devalue Their Currency? 
The ongoing appreciation of the dollar has negativley impacted China’s economy.  As the dollar has appreciated against virtually all other currencies, so has the yuan.  In the case of the dollar, policy divergence and strong economic growth (at least realtive to other regions) justify its strengthening.  The Chinese yuan, on the other hand, is just along for the ride and its economic fundamentals are starkly different. 
 
Robust export growth has been the basis of China’s remarkable economic growth for years and the appreciation of the yuan has impacted their economy adversely.  Economic growth has declined markedly in 2015 and will hit a 25-year low even if it meets the government’s 7.0% target for growth.  Some economists believe China’s economy is already growing at far less than the official target.   With Chinese exports to the U.S., Japan and Europe all slumping sharply in July, devaluing its currency to spur exports is a logical policy action to stimulate Chinese economic growth. 
 

 
What Do Advisors Need to Know About This?
 
Financial Markets Will Be More Impacted by China’s Move Than the U.S. Economy
The impact of China’s devaluation on the U.S. real economy will be marginal.  The key reason is that the United States economy is not dependent on trade for growth.  International trade with all nations accounts for only about 10% of U.S. GDP.  American firms exported nearly $125 billion in goods and services to China in 2014, however these exports accounted for only 7% of total American exports and less than 1% of U.S. GDP last year.
 
The Chinese devaluation does, however, reinforce current market trends.  Namely, a yuan devaluation serves to: 
o   Make the dollar even stronger
o   Weaken commodity prices further
o   Act as another source of volatility for equity and FX markets
 
The Yuan’s Devaluation Will Not Trigger the Start of a Global Currency War
Uncertainty around the extent and pace of the yuan move was removed when Chinese authorities made clear their intentions of a gradual and moderate devaluation.   Moreover, the threat of other nations following suit with multiple rounds of competitive devaluations has not materialized.   In fact, the South Korean and Philippines central banks both had meetings this week and neither responded to the yuan’s depreciation.  This strongly suggests that fears of a global - or even a regional - currency war are wildly overblown. 
 
 
Devaluation Will Have Very Limited Influence on FOMC Interest Rate Policy
When it comes to the timing of rate normalization, the FOMC is not likely to be influenced by China’s devaluation for several reasons:
 
o   First, while news of China’s actions sent equities lower somewhat, it did not directly impact U.S. financial conditions.  That is, it did not affect borrowing costs or spreads for U.S. consumers, corporates or banks. 
 
o   Second, we already noted the minimal economic impact of China’s devaluation.  Hence, it is very unlikely to affect the U.S. trend of strong job growth, for example. 
 
However, it is possible a sustained devaluation campaign by the PBOC could influence the pace of subsequent FOMC rate increases.  An ongoing or more severe devaluation of the yuan would exert downward pressure on overall import prices in the coming months.  If sustained over time, these potential deflationary forces could weigh on domestic inflation and warrant a slower pace of policy rate increases than is contemplated now. 

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