The implications of China’s historic Yuan devaluation
by
Monique Frederick, CFA, FRM
Year to date Offshore RenminbiSource: Bloomberg Financial L.P.
On August 11th, the world’s second largest economy roiled markets by allowing a more market-driven exchange rate mechanism to determine the value of the Yuan. The result was a 3.4% plunge against the dollar, the largest two-day slide in over two decades. The move by the People’s Bank of China (PBoC) came as a shock, causing panic in global markets.In an effort to combat the precipitous drop and stabilize the Yuan, the PBoC tripled the amount of cashinjected in the financial system in its open-market operation the following week.
Why now?
Based on the economic data coming out of China, depreciation of the Yuan should not be that surprising. Policymakers’ efforts to stimulate the economy by cutting interest rates, lowering bank reserve requirementsand propping up the stock market have not delivered the desired result.Chinese exports have been on a downward trajectory, dropping 8.3% in July. Meanwhile, as a result of the defacto peg against the US dollar, the Yuan had appreciated 13% in the last year on a real trade-weighted basis. In the end,PBoC gave into pressures to weaken the currency to boost demand.
It is also believed that depreciation of the Yuan was an attempt by Chinese policymakers to improve its case for obtaining reserve currency status from the International Monetary Fund (IMF). During its last review in 2010, the Washington-based fund rejected China’s bid for inclusion in the Special Drawing Rights basket of currencies on the basis that the Yuan was not “freely usable”.
In light of the public condemnation of China’s actions,it is worth noting that China is not the only country that has embarked on monetary quantitative easing programs. The US, Japan and the ECB have all been down that road and China is just the latest country to join the party.
In reality the Yuan’s depreciation was trivial when compared tothe depreciation other emerging market currencies have experienced this year. Perhaps investors are more worried about the distress signal this move sends about the future growth prospects for China and the rest of the world. In effect, the actions of the PBoCcan be seen as confirmation of slowing economic growth in Asia’s largest economy, and the implications for the rest of the world are alarming.
Who suffers?
Emerging-market assets have been the hardest hit asChina’sslowdown spurs further commodity price declines. As the world’s largest consumer of commodities and metals, decreased demand from China is to the detriment of commodity producing countries like Brazil and Australia, as well as China’s Asian trading partners.
European export-led economies like Germany,with significant exports to China and other emerging markets, also face headwinds. Not only would one expect exports to China to decline, devaluation of the Yuanalso makes Germanyand other export-based economies less competitive.
Companies who derive considerable revenue from Mainland China will be adversely affected by a lower Yuan. This includes semiconductor companies like Marvel Tech, Qualcomm, and Texas Instruments, as well as restaurant operator Yum Brands who all generate more than 40% of revenue in China.
Chinese companies who have issued USD and Euro denominated debt may face additional challenges as their debt servicing costs rise. According to Bloomberg compiled data, Chinese companies have $529 billion in such loans and bonds outstanding.As such, concerns of rising company defaults are certainly warranted.
Who benefits?
Clearly a lower Yuan is advantageous for Chinese exporters as they try to regain competitiveness. Likewise, Americans and other foreign consumers also reap the benefits of cheaper Chinese goods. Moreover, US companies who source from China can now do so at lower costs. Admittedly, US exports to China will suffer but US total imports from China trump exports by a ratio of 2.9 to 1.
Although a lower Yuan is by and large positive for China’s exports, the minor devaluation in August is unlikely to boost exports substantially.Similarly the impact on importers of Chinese goods is not material. Still, now that China has taken the first step towards a more liberalized exchange rate, and as the Yuan continues to experience downward pressure, further depreciation is highly probable.On the other hand, substantial devaluation is not expected as this would be counterproductive and jeopardize the country’s chances in obtaining reserve currency status.
Sources: Bloomberg
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.