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China's surprise devaluation last Tuesday has left the markets gasping. The Yuan was devalued by 1.9%, the biggest drop until now. Over the next couple of days the currency lost another 1%. "While the depreciation seems small in the scheme of things, the announcement is a game-changer, but a key unknown at present is how far the Yuan will be allowed to depreciate." Perpetual head of investment strategy Matt Sherwood said. (Sydney Morning Herald, Aug. 12, 2015)
How China manages its currency
This concern is derived from the way China manages its currency. The Yuan's value unlike other major currencies is not determined by free trading. Its value is fixed on the basis of a 'basket of currencies', the main currency thought to be the U.S. Dollar (USD). The People's Bank of China, or PBoC, China's central bank, sets a target value for the Yuan and allows the currency to move 2% either way from that level. On Tuesday, the PBoC set a target which was 1.9% lower than the Monday's level, triggering the devaluation.
Economic slowdown
A big reason for the unexpected move could be that the economic scenario in China is worse than earlier thought. Recently, the IMF revised growth estimates for the current year downwards from 7% to 6.8%, the slowest in more than two decades. Data for July too is disappointing. Industrial output grew just 6% on an annual basis, below the 6.6% expected by the markets. The growth in June was higher at 6.8%.
The Chinese labour market has been tight for some time now with the ratio of job offers to seekers being on an upward curve. Earlier this year, this ratio started falling. "I suspect the breakdown of the upward trend in the job offers-to-seekers ratio came as a major shock to the Chinese authorities." Nomura economist Richard Koo said in a recent note. (Businessinsider, Aug, 13, 2015)
China has been desperately trying to pump the economy through a massive government funded infrastructure drive. Yet the pass through from these measures into the economy is likely to be limited. Says Koo, "Now that the nation's working-age population is starting to decline, the only way the economy can grow is via higher productivity per worker, which requires an efficient allocation of resources throughout the economy. That cannot be achieved if the government is allocating substantial resources to public works projects."(Businessinsider, Aug, 13, 2015)
China's defence
The Chinese central bank has claimed that the devaluation actually paves the way for the free trading of the Yuan. The Yuan's value has been rising in the last few months, since the Yuan is pegged in a way to the USD. The People Bank's defence is that it was only reacting to the market and not trying to manipulate it. "The devaluation of the Yuan should not be seen as a sign of China wanting to wage a currency war, but it is more to do with China's ambitions to facilitate Yuan's inclusion in Special Drawing Rights (SDR)," according Dennis Tan, forex strategist, Barclays.(Moneycontrol, Aug. 14, 2015)
Dan also expects the Yuan to slide further, though gradually, by year's end. "Given the macro backdrop, we are in an environment where the Fed is about the hike interest rates and is going to be the first major Central Bank in the world to hike rates, that is helping to support the dollar and you have seen that most of the emerging market (EM) currencies of the world have already adjusted versus the dollar and now China seems to be the laggard in this global foreign exchange adjustment versus the dollar."
"The 2 or 3 percent devaluation of the Yuan [against the U.S. dollar] is completely meaningless," Marc Faber, publisher of the Gloom and Doom Report said. "The Chinese Yuan has appreciated by 80 percent over the past two years against the yen." (CNBC Aug. 14, 2015)
Asian concerns
There are broader implications for the Asian region too. The 1997 Asian Financial Crisis began, eerily, in much the same way. China had devalued a couple of years earlier and when the Federal Reserve raised rates, the currencies of over leveraged countries went bust. In the present situation, other economies which compete in similar product categories with China, like South Korea, Malaysia, Taiwan, Vietnam and Thailand may see some economic headwinds. They may also resort to devaluing their currencies to maintain their competitiveness vis-s-vis China.
"The start of the Fed's rate rise cycle during the same year was the straw that broke the camel's back. No wonder that the repercussions for emerging markets of a similar change in the direction of Fed policy have been an issue of lively debate among investors," Lombard Street Research senior economist Shweta Singh said referring to the earlier crisis.
The U.S. Federal Reserve
Some analysts speculate that China simply pre-empted the U.S. Federal Reserve which was planning to raise rates in September. China's action this week may persuade the Federal Reserve to put off the rate hike to December. In the recent past, several other central banks have attempted to raise interest rates, but had to give up; since prices started to fall even as growth slowed. The Chinese act has likely reduced the room for the Federal Reserve to act. "It may also limit how far the US Fed can raise rates given the rising US dollar has already tightened financial conditions," Matt Sherwood said. Further, he said, "It will be interesting to see if investors begin to downgrade US earnings in the process, as the currency effect is larger on US equities than on the US economy."
What next
Still there is light at the end of the tunnel. "We do not think this will be a lasting trend," senior markets economist for Capital Economics, David Rees says."For a start, if the PBoC does allow the market to play a greater role in driving the renminbi exchange rate, we doubt it will be long until sentiment begins to turn. We have long argued that the Chinese economy will avoid a hard landing. And while activity data that were published on Wednesday were weaker than expected, an increase in credit growth may be an early sign that prior stimulus measures are beginning to feed through into stronger economic activity." (Sydney Morning Herald, Aug. 13, 2015)
Not everybody is comforted though by this thought. Nomura Global Markets Research recently estimated that the Chinese Yuan's REER (real effective exchange rate) had appreciated by 14% over the past 12 months and by 30% over the past five years. REER is the inflation-adjusted exchange rate relative to a basket of currencies of major trade partners. If that be the case, the current round of Yuan depreciation could well be the beginning of a deeper move in this major currency. And, its exactly this potentially deeper move that's keeping markets on tenterhooks. What if China devalues its currency by another 10% in phases? Will Asian economies that compete with China for exports be forced into a round of competitive devaluation? What then happens to FII investments in stocks and bonds of these countries? Will they sell out fearing a currency war that can only hurt their dollar returns?
Has a bruising currency war just begun, with this Chinese move? Only time will tell.
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