For the first time since 1993, Chinese authorities devalued their currency. Further weakening of the renminbi is likely, and capital outflows from China will probably not stop anytime soon. Coming as it did on the heels of this year’s several shocks and shake-outs – the Bund market correction in April and May, the latest Greek drama in June and the commodity sell-off in July – the surprise move injected a fresh dose of uncertainty into markets and sparked yet another bout of risk-averse investor behaviour. Further weakness in China’s currency also poses a risk for European, Japanese and US companies. The impact, if sustained, could lead to a tightening of financial conditions in the rest of the world and may even lead to a shallower rate path for the US Federal Reserve.
Divergence in real effective exchange rates: China vs Global Emerging Markets
Renminbi rate was unsustainable
China’s authorities had little choice but to start allowing its currency to weaken, given the accelerating depreciation of the other emerging market (EM) currencies. Since the summer of 2011, the average EM real effective exchange rate (REER) has depreciated by some 10% while the Chinese REER has appreciated by 15%, bringing the renminbi’s total real appreciation over the last 10 years to 40%. The stable renminbi exchange rate was becoming more unsustainable by the day. As other EM currencies continued to depreciate, the Chinese export sector was becoming less competitive. This was reflected in the negative Chinese export performance and the persistent speculation about Chinese exporters moving towards bankruptcy.
More depreciation can be expected
The depreciation is not likely to stop at the 3% devaluation that has so far taken place, nor at the 4% currently priced for the coming 12 months in the futures market. The authorities aim to narrow the gap showed in the chart. For that to happen, China’s REER must weaken more than that of Global Emerging Markets (GEM). The next steps, then, are likely to depend on the movements of the other EM currencies. Pressure on those currencies is still intensifying due to Chinese growth concerns and the unwinding of the USD-EM carry trade. The potential depreciation of the renminbi is therefore likely to be substantially larger than 4%.
Authorities fighting to avoid loss of confidence
A key question is: to what extent are the Chinese authorities still in control? The ineffective economic stimulus of the past year, the aggressive manipulation of the stock market in the past months and the growing number of political arrests this year all suggest that the country’s leadership is struggling with top-down management of the economy and that it is fighting hard to avoid a more widespread loss of confidence.
By allowing more room for the currency to adjust, the authorities are also trying to regain control of monetary policy. The strong REER was one of the reasons for capital outflows. In the past year, capital outflows have been large: USD 1 trillion since May 2014. The total amount of capital that has left China just this year has exceeded the liquidity created by the cuts in interest rates and reserve requirements, which explains why the monetary stimulus measures have not been effective so far.
Capital outflows unlikely to decrease in near future
Capital outflows are unlikely to decrease any time soon. With expectations for more depreciation likely to move up, the willingness to hold CNY in the coming period will probably go down even more. With growth unlikely to recover in the short term, the main risk is that capital outflows will accelerate and that the number of corporate defaults will increase. During the years of the renminbi’s appreciation, Chinese companies issued some USD 3 trillion worth of foreign debt. With the corporate sector in China already under a lot of pressure from the economic slowdown and profit margins very thin, the weakening CNY could create problems.
The Chinese devaluation also creates more risks for EM currencies, not only because it could kick-start another round of competitive devaluations in the emerging world, but also because it could lead to uncontrollable capital outflows and credit problems in China. Pressure on EM currencies had already intensified due to the deteriorating growth picture, and the deepening political crises in Brazil, Malaysia and Turkey have reduced the likelihood of structural change anytime soon in these countries.
Markets faced with new uncertainties
Following the news of Chinese devaluation, it did not take long before investors’ behaviour became more risk-averse, reflecting their fears of escalating currency wars, erosion of Chinese policy makers credibility and rising market fragility through contagion into commodity markets or sectors or regions sensitive to commodity dynamics. The unexpected nature of the move and the increased probability of further renminbi devaluation – despite policy-makers’ efforts to suggest this was a “one-off” adjustment – have introduced substantial uncertainty into the market outlook.
The shift towards a more market-driven exchange rate and the likelihood of further weakness in the renminbi forms a risk for companies in Europe, Japanese and the US. The actual impact will depend on the magnitude of the currency move. If sustained, this would lead to a tightening of financial conditions in the rest of the world and may even lead to a shallower rate path for the US Federal Reserve. Another element to watch is the reaction of other Asian countries, especially South Korea and Taiwan. If anything, this feeds the global deflationary trend. What is certain is that this is an additional sign that Chinese economic growth is under pressure, as witnessed by the latest trade statistics.
The developed market sectors most at risk are car companies, industrial companies and luxury goods companies. The impact is threefold. There is first of all a direct translation effect, as the value of Chinese sales becomes less. Secondly, Chinese competition in international markets will heat up. Thirdly, it is a sign that economic growth in China is weaker than expected. The weakness in car sales is a good example, and is bad news for the German equity market, where the automobile industry is heavily represented.
More generally speaking, the impact on monetary policy expectations and the additional deflationary pressures caused by a prolonged Chinese currency depreciation could spark a renewed interest in the search for yield theme. With these latest trends in our mind, we became more positive on Utilities at the detriment of Consumer Discretionary. We also reduced our exposure in Japan and in Developed Asia Ex-Japan, primarily due to the commodity-heavy Australian market.