China’s move to weaken its currency on Tuesday morning came as a surprise. The size of the devaluation may appear insignificant, but it represents a u-turn in the country’s currency policy.
The dollar peg was seen as a tool to attract foreign investment – luring it in with a stable currency – but it also helped the yuan to gain the status of a reserve currency; it went on to form part of central banks’ forex reserves around the world.
Growth is slowing down quickly in China. The Chinese Government was hoping to kick-start domestic consumption thanks to a vibrant stock market, which translated into wealth effects for Chinese households.
With the recent crash and the panicked official reaction to counter it, these hopes have been dashed. The fall in commodity prices around the world (these are currently at their lowest levels in twelve years) is undoubtedly linked to recent events in China, where much slower economic growth has meant lower demand for commodities in general.
Only option left
The only option left was to boost exports – which fell sharply recently – by devaluing its currency. Recently, the yuan has been under pressure and, in order to maintain its peg, the PBoC had to sell dollars, which explains why its domestic reserves have fallen significantly since the beginning of the year.
Weakening the currency could be seen as a cheap way to boost exports, but that signal will push many investors and corporations to sell even more yuan, making it harder for the People’s Bank of China (PBC) to oversee a steady depreciation of the yuan. We therefore expect more downside on the Chinese currency, but the pace of the depreciation is difficult to assess given the opacity of policy decisions in China.
China’s desperate efforts to enhance its competitiveness are putting a lot of pressure on its Asian neighbours. This is why currencies in the region are tumbling: the South Korean won, the Australian dollar, the Thai baht and the Taiwanese dollar have all, amongst others, fallen sharply against the greenback.
Deflationary shock
Once again we find ourselves facing a deflationary shock. China is a heavyweight in international trade and, whilst we do not expect a repeat of the 1997 crisis, the rest of the global economy was much more vibrant back then, and the only country not to devalue its currency was China itself.
Nowadays, in a world where demand is already sluggish, these beggar-thy-neighbour policies could have a lasting impact on growth and earnings.
For the last two years we have not recommended holding or buying bonds in local EM currencies; this has also been true for yuan-denominated securities. We recommend continuing to have no exposure to these securities.
We remain highly cautious on EM equities, as what we have outlined above is going to have a negative impact on margins, earnings and cash flows. EM equities will continue to underperform, so we recommend staying markedly underweight, as it is too early to go back into them.
On alert
We have to assess the impact on developed equity markets of this reversal of policy in China. Might it shift when the Fed starts to normalise its monetary policy? For now, we do not know, although it will undoubtedly weigh on import prices and consequently on inflation figures.
Central banks are on alert, ready to provide more liquidity should the markets and risk assets come under too much pressure.
