Talks about a currency war, doubts about Chinese policymakers’ credibility and worries over the Chinese economic slowdown and its ripple effects have certainly ignited risk aversion among investors. Yet to call the recently engineered devaluation by the People’s
Contrast the yuan’s fortunes with Switzerland’s decision to end the Swiss Franc’s cap with the Euro in 2015, for example, which caused its currency to rise by more than 19% with markets reacting in dramatic fashion. Over the past year the Euro has declined by around 15% against the greenback.
There has been much talk about the possible rationale behind China’s currency move. A popular theory is that it was a move to boost growth and stimulate the export sector.
However, a 4% nominal decline of the yuan has little impact in terms of real effective exchange rates. According to the Bank for International Settlements (BIS), the Basel-based organization serving central banks around the globe, the yuan is about 32% overvalued compared to its trading partners and the most expensive among 60 countries - if Venezuela is excluded.
Valentijn van Nieuwenhuijzen, Head of Multi-Asset at NN Investment Partners (NNIP) in The Netherlands, which manages around €184 billion (c.US$206bn) in assets for institutions and individual investors globally (as of 30 June 2015), says: “In comparison, both India and Indonesia are undervalued by about 10%.”
The yuan’s “tiny devaluation” could hardly lift export competitiveness. Moreover, the PBoC has intervened to prevent the yuan from depreciating excessively, which suggests that a “currency war is not on the cards”, he asserts.
Yuan Spot Rate vs. US Dollar
Since the move, the yuan spot rate has been quite steady around 6.40 versus the US dollar and over the past month since 5 August the US$/CNY rate has traded in the range of 6.18566 (low) to 6.45025 (high).
The rate in the past few days being fairly steady in the 6.35-6.36 range prior to markets in China being closed this Wednesday and Thursday to mark the 70th anniversary of the end of World War II. Last November the exchange rate was hovering around the 6.11 mark.
Of course all this might be a bit academic if the Shanghai Composite index, which has lost around 38% in around two months in recent months - and erased all the gains for 2015 – declines even further.
Having peaked at 5,166 points back in June the index closed at 3,160.167 on 2 September 2015. Although -0.88% year to date the index is still up 39.30% from one year ago. But some have suggested a further descent to 1,500. Now a 50% decline on the Shanghai Composite’s current levels would be interesting and rattle nerves.
The Chinese authorities have a clear interest in “keeping the pace of depreciation moderate” says Van Nieuwenhuijzen, who graduated in economics from the University of Amsterdam with a specialization in international macro-economics in 1998.
Chinese companies have a substantial amount of hard currency debt, so a rapid depreciation could deal a “fatal blow” to corporate balance sheets. “If the depreciation happens at a moderate pace, this will give the corporate sector more time to adjust,” the Dutchman says.
Van Nieuwenhuijzen thinks that the ultimate goal of China’s decision to allow the yuan to depreciate is to allow for a decoupling between US and Chinese monetary conditions. He says: “The exchange rate has always been a favourite tool of China in order to achieve policy goals. Before 2008, the goal was to limit yuan appreciation, which led to a substantial accumulation of FX reserves.”
“In a sense, the US economy absorbed a substantial part of the concomitant Chinese excess savings, which contributed to the inflation of the US housing bubble,” he adds.
Credit and Investment Bubble
After 2008, China embarked on a huge credit and investment bubble of its own. As long as the concomitant economic boom was in full swing, strong growth and an appreciating currency were perfectly compatible policy objectives because the latter reduced the risk of overheating.
The boom ultimately became unsustainable and since about two years Chinese policymakers are aware that excessive credit-driven investment growth needs to slow down. Hence, over the past two years the objectives of strong growth and a strong currency were joined by a third one that can be labelled as “managed deleveraging/financial sector liberalization” according to van Nieuwenhuijzen.
He adds: “What’s more the fundamentals of the economy have changed so as to render these objectives ultimately inconsistent. After all, maintaining decent growth rates in the face of deleveraging usually requires a weaker exchange rate and thus looser domestic liquidity conditions.”
In addition, in the run up to the start of the US Federal Reserve’s (US Fed) tightening cycle, US monetary conditions have tightened considerably, mostly so via a stronger dollar which caused the yuan to strengthen substantially as well.
Since May 2014, China has seen persistent capital outflows, which means that the PBoC has had to intervene to maintain a stable dollar-yuan exchange rate. Indeed, the pace of outflows is concerning. Between May 2014 and the end of July 2015 China has suffered capital outflows worth $680bn.
According to projections from
And, even though there is still a very big war chest in the form of FX reserves (around $3.6 trillion) left to stabilize the currency, the ability to do so is clearly not infinite.
Medium To Longer Term View
In the medium to longer term China’s currency move is seen by NNIP as a “positive development” as it reduces the inconsistencies in the afore-mentioned policy objectives. However, the consequences for the short term are “more uncertain” says the Dutchman.
He notes on risks that: “The main short-term risks of the Chinese move clearly reside in emerging markets (EM) and maybe not even so much in China, as it has three lines of defence, which will allow it to manage the process at least in the short term: a current account surplus, a war chest of reserves, and the existence of capital controls.”
As for the rest of the EM space the crucial issue is to what extent contagion in FX space will continue. “If currencies continue to depreciate, the cyclical outlook in these countries could deteriorate as policymakers will eventually have to tighten policy more to stabilize the situation,” van Nieuwenhuijzen contends.
In the developed market space, the deflationary effect of Chinese and EM currency depreciation - and falling commodity prices – “increases the probability” of a delay in monetary tightening by the US Fed. Indeed, according to the
Should global risk appetite show signs of life again in the coming weeks, NNIP still believes that the “US Fed will start to hike in the September-December window”. Only really big moves in the oil price, the dollar or global risk appetite would make the Fed refrain from doing so. For China the risk and pressure is still on.
