China’s decision to change the method of setting its currency exchange rate caused global shock waves last week. ‘Biggest devaluation in two decades!’ was a typical headline.
Is this a real story? Is the world about to experience even more deflation risk as a result of a 4 percent drop in China’s yuan over a two-day period? Does the addition of a new uncertainty–possible further yuan depreciation–usher in another leg down for already challenged emerging market (EM) assets? Or is this a storm in a Chinese teapot?
Let’s first inject some perspective into this debate: a 4 percent drop is not big. Consider:
1. The currency is one of the few to have appreciated against the US dollar over the past five years (up 6 percent as of last Thursday), Thomson Reuters data show. The yuan is up about a quarter on a trade-weighted basis and has trounced every EM currency over the same period, the data show.
2. A real depreciation, say 10 percent or more, would stimulate exports and add to global deflation. This simply hasn’t happened–yet.
3. The small move modestly helps net trade, in itself a modest contributor to China’s economic growth. (It does help at the margin–and it has the potential to boost asset prices against a backdrop of slowly declining GDP growth.)
What matters more is whether this change ushers in a period of sustained currency depreciation. The yuan’s slow and substantial appreciation over the past decade indicated Beijing had abandoned the use of foreign exchange (FX) policy to stimulate the economy. Dusting off this tool and re-applying it would constitute a threat to EM stability in particular.
If we take the People’s Bank of China (PBC) at its word, the change toward a market-determined exchange rate is part and parcel of financial liberalization – and nothing more. The jury is still out. Do take into account that the world’s second-largest economy faces material challenges. Among them: a currency that was dragged higher by a strengthening U.S. dollar at a time when the economy is slowing. Asian and commodity-producing economies in particular depend on China, and catch a cold when it sneezes.
China’s authorities have made it clear through verbal and financial intervention that they feel uncomfortable about excessive currency volatility. We would expect a firm hand on the tiller to help smooth a depreciation. Beijing has substantive tools at its disposal: gargantuan foreign exchange reserves, close control over the conduits of domestic finance, a current account surplus and a near-monopoly on yuan assets held on shore. A slow and managed depreciation would not surprise me.
Where does this leave EM assets? Weak or falling domestic demand and trade growth, an appreciating U.S. dollar and slumping commodity prices have already taken a toll. The prospect of a weakening yuan and subsequent rounds of competitive EM currency depreciations make matters worse. They only add to other challenges such as dwindling corporate profits, declines in productivity and a dispirited investor base. At the very least, losing the anchor of a near-fixed exchange rate raises volatility. EM assets are starting to look cheap, but it’s too soon to grasp this particular nettle, as I wrote the other week in ‘Emerging market equities: close but no cigar‘.
So which is it? A yuan yawn or nightmare? Neither one appears appropriate at this time. It is more than a yawn, particularly for the emerging world. Yet it is hard to see it quickly morphing into a nightmare. All we know is that the yuan is an important yarn with an unknown ending.
For Chinese citizens, the yuan depreciation appears a side show for now. The story did not show up in the top 10 most popular searches on China’s domestic search engine Baidu on Thursday (not for the day and neither for the week). The currency news was edged out by entertainment gossip, crime, the explosion in the harbour city of Tianjin and a NASA robot cruising the planet Mars transmitting an image of what looked like a woman, the website showed.
The yuan yarn could dissipate from global financial markets as well. Markets care about the shark closest to the boat, as my colleague Rick Rieder says. They are unable to focus on more than a single issue at a time. The next cab off the rank is next month’s U.S. Federal Reserve meeting–when we expect the central bank to raise interest rates for the first time in almost a decade. Federal funds futures contracts had slipped to pricing in less-than-even odds for a September rate increase by Thursday, according to Bloomberg data. This appeared to be one of the biggest overreactions of the week’s febrile markets.