We think that the ultimate goal of the decision to allow the yuan to depreciate is to allow for a decoupling between US and Chinese monetary conditions. In the medium to longer term we believe this is a positive development.
Global stock market sell-off accelerates
Chinese currency action has rippled global markets
Markets are still dealing with the aftermath of the devaluation of the Chinese yuan. The engineered devaluation by the People’s Bank of China (PBoC) itself is not dramatic, as the yuan has since depreciated by only around 3%. For example, Switzerland’s decision to end the Swiss franc’s cap with the euro in January this year caused its currency to rise by more than 19%. Markets however reacted dramatically. Talks about a currency war, doubts about Chinese policymakers’ credibility and worries over the slowdown of the Chinese economy and its ripple effects sparked fresh bouts of risk aversion among investors. This while sentiment towards China was already negative following weak economic data and the equity market turmoil.
SDR argument more plausible than growth argument
There has been a lot of talk about the possible rationale behind China’s currency move. A popular theory is that it was a move to boost growth and stimulate the export sector. However, a 3% nominal decline of the yuan has little impact in terms of real effective exchange rates. According to the Bank of International Settlements, the yuan is about 32% overvalued compared to its trading partners and the most expensive among 60 countries (if Venezuela is excluded). In comparison, both India and Indonesia are undervalued by about 10%. The yuan’s tiny devaluation could hardly lift export competitiveness. The PBoC has also intervened to prevent the yuan from depreciating excessively, which suggests that a currency war is not on the cards. Over the past week, the yuan spot rate has been steady around 6.39 versus the US dollar.
The Chinese authorities also have a clear interest in keeping the pace of depreciation moderate. Chinese companies have a substantial amount of hard currency debt (even though how much exactly is very unclear) so a rapid depreciation could deal a fatal blow to corporate balance sheets. If the depreciation happens at a moderate pace, this will give the corporate sector more time to adjust.
The argument that Beijing’s decision to amend the currency mechanism is motivated by the need to speed up exchange rate reform seems more plausible. The authorities have made no secret of its desire to include the yuan in the International Monetary Fund’s (IMF) Special Drawing Rights basket of currencies, which includes the US dollar, euro, yen and pound. One criterion is that the currency must be “freely usable”. Indeed, the IMF has been unperturbed by China’s devaluation. The monetary fund saw the move as a welcome step in allowing market forces to have a greater role in determining the exchange rate and said the yuan was likely to become a freely-floated currency in the next few years.
Decoupling between US and Chinese monetary conditions
We think that the ultimate goal of the decision to allow the yuan to depreciate is to allow for a decoupling between US and Chinese monetary conditions. The exchange rate has always been a favourite tool of China in order to achieve policy goals. Before 2008, the goal was to limit yuan appreciation which led to a substantial accumulation of foreign exchange (FX) reserves. In a sense, the US economy absorbed a substantial part of the concomitant Chinese excess savings which contributed to the inflation of the US housing bubble. After 2008, China embarked on a huge credit and investment bubble of its own. As long as the concomitant economic boom was in full swing, strong growth and an appreciating currency were perfectly compatible policy objectives because the latter reduced the risk of overheating. The boom ultimately became unsustainable and since about two years Chinese policymakers are aware that excessive investment growth driven by bank lending needs to slow down.
Hence, over the past two years the objectives of strong growth and a strong currency were joined by a third one which can be labelled as managed deleveraging/financial sector liberalization. What’s more, the fundamentals of the economy have changed so as to render these objectives ultimately inconsistent. After all, maintaining decent growth rates in the face of deleveraging usually requires a weaker exchange rate and thus looser domestic liquidity conditions.
However, in the run up to the start of the Fed’s tightening cycle, US monetary conditions (short-term rates and the exchange rate) have tightened considerably, mostly so via a stronger dollar which caused the yuan to strengthen substantially as well. Since May last year, China has seen persistent capital outflows which means that the PBoC has had to intervene to maintain a stable dollar-yuan exchange rate. Even though there is still a very big war chest in the form of FX reserves left to stabilize the currency, the ability to do so is clearly not infinite. For now, the PBoC seems determined to keep the yuan stable around 6.40 until the selling pressure abates.
Short-term risks mainly reside in emerging markets
In the medium to longer term we think China’s currency move is a positive development as it reduces the inconsistencies in the afore-mentioned policy objectives. However, the consequences for the short term are more uncertain. The main short-term risks of the Chinese move clearly reside in emerging markets (EM) and maybe not even so much in China, as it has three lines of defence which will allow it to manage the process at least in the short term: A current account surplus, a war chest of reserves and the existence of capital controls. As for the rest of EM space the crucial issue is to what extent contagion in FX space will continue. If currencies continue to depreciate, the cyclical outlook in these countries could deteriorate as policymakers will eventually have to tighten policy more to stabilize the situation.
We do not expect a delay in the Fed rate hike
In developed market space, the deflationary effect of Chinese and EM currency depreciation – and falling commodity prices – increases the probability of a delay in monetary tightening by the Fed and of more quantitative easing (QE) by the ECB and Bank of Japan (BoJ). According to the CME Group’s FedWatch calculator, the probability of a September hike has declined to 28% while the likelihood of a December increase is now 60%.
If global risk appetite does not suffer too much in the coming weeks on the back of the Chinese move, we still believe that the Fed will start to hike in the September-December window. Only really big moves in the oil price, the dollar or global risk appetite would refrain the Fed from doing so. The threshold for both the ECB and the BoJ is probably somewhat bigger than for the Fed, because QE is a big bazooka instrument which cannot be used for fine tuning.