On Tuesday, Wednesday and again today, the People’s Bank of China (PBOC) announced that it was devaluing its currency by 1.9%, 1.6% and 1.1%, respectively, against the dollar. Stocks responded by plunging around the world on Tuesday and early Wednesday before stabilizing by the close yesterday.
Investors are worried that China may not be done devaluing its currency, but the truth is, no one knows what will happen next. When the leaders of the second largest economy in the world decide to devalue their nation’s currency, there is cause for concern. However, it is a widely-known fact that China’s economy is weakening, and a lower currency makes its exports cheaper on world markets.
In fact, falling exports are likely the catalyst for the latest currency move. Over the weekend we learned that China’s exports fell below expectations, dropping 8.3% in July year-over-year, far worse than the forecasted 1.0% decline. Producer price inflation slipped to its lowest level since October 2009, down 5.4% year-over-year following the 4.8% slide posted in June. Corporate profitability in China has been under pressure. And the Shanghai Composite Index, ahead of the PBOC’s move, had plunged nearly 30% from its June high.
Commentators noted that the surprise devaluation is the largest in two decades. The PBOC said the change was a “one-time depreciation” to get the yuan more aligned with supply and demand. To put this into context, let’s look at a chart of the value of the Chinese yuan against a large basket of other currencies provided by the Bank for International Settlements.
As we can see, the yuan has risen significantly over the last two decades as the Chinese economy has been the world’s juggernaut, with annual growth over 10% until recently. The government forecasts growth of 7% for this year, but other analysts believe it may only be in the 4-5% range. If true, that makes it even more understandable for the PBOC to devalue the yuan.
With the yuan getting stronger over the last 20 years, China experienced an almost constant net inflow of foreign capital. The economy was booming and everyone wanted to get a piece of the action. China’s foreign exchange reserves increased from almost nothing in 1995 to about $4 trillion a year ago. But over the past year, China’s forex reserves have dropped from $4 trillion to an estimated $3.2 trillion, which means China has experienced net outflows of $800 billion in capital.
As long as China’s reserves were rising, it made sense for the PBOC to allow the currency to appreciate. But now that reserves are falling, the central bank wants the currency to depreciate. The question is, by how much? Estimates I’ve seen, including from Deutsche Bank, suggest the yuan was overvalued by 5-10% before the latest adjustment.
While the latest adjustments were the largest in two decades, the US Dollar/Chinese Yuan ratio moved only from 6.21 to 6.43 on Wednesday. That’s a rise of less than 3% as of yesterday’s close.
The yuan will probably continue to fall against the dollar until it reaches a level that brings capital inflows and outflows closer together. That’s how currencies compensate for differences in the economic performance and relative attractiveness of economies. Yet with the Chinese economy stronger than most, I would not expect the yuan to crater.
A somewhat weaker yuan, if it continues, will make Chinese goods a little cheaper for US consumers. But to hear some of the alarmists over the last few days, you’d think we’re headed for the next financial crisis as a result of China’s latest move. I don’t see that.
In my view, the severe reaction in the US and global equity markets was overdone. While I have been predicting a downward correction in the equity markets, and still do, this week’s reaction to the yuan devaluation is overblown in my opinion – that is, unless the yuan craters.
Finally, everyone is now wondering if the combination of the Chinese stock market collapse, the devaluation of the yuan and the latest move down in stocks around the world, will cause the Fed to delay the expected first rate hike at the September 16-17 policy meeting.
Fed Vice Chairman Stanley Fischer made comments on Monday to the effect that a September rate hike is not a done deal. While he noted that employment growth has been brisk, he wants to see more evidence that inflation is rising.
Keep in mind that the meeting is five weeks away. A lot can change between now and then.
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