False Alarm: China’s Yuan Devaluation Is Not a Prelude to Armageddon
Despite this being the dog days of August – with the usual slowdown in the financial news cycle – some of the headlines and commentary of the past few days might have gone too far in terms of characterizing the devaluation of the Chinese yuan. It is probably a stretch to say that a global currency war has broken out, or that Chinese officials are in a panic because the economy is slowing sharply. However, the surprise announcement of a devaluation – albeit small – did jolt global equity and fixed-income markets.
As seen in the chart below, the yuan has appreciated rapidly since the middle of 2014. This reflects the fact that the Chinese currency has been pegged to the U.S. dollar, which has strengthened significantly in anticipation of the Federal Reserve’s abandoning its zero interest rate policy.
Source: Bloomberg, Milken Institute
Although there has been much speculation by experts and pundits about the reasons for the devaluation, it’s reasonable to say that the primary motivation for China’s action is to gain policy flexibility while beginning to move the yuan toward a market-determined exchange rate. With a number of indicators pointing to a slowdown in the economy, the authorities would like to have more leeway to relax monetary policy both through changes in reserve requirements as well as policy interest rates. However, with the Federal Reserve poised to raise interest rates, the Chinese authorities realize that some action on the exchange rate is needed in order gain flexibility in other areas, including monetary policy. The dilemma for the Chinese central bank is to manage the exchange rate to free up other policy options, while not triggering a sudden exodus of capital from the country – with its own set of negative consequences.
The devaluation of the yuan and the process of its daily fixing also can be viewed as an orderly step on the road to the currency’s becoming a part of the International Monetary Fund’s Special Drawing Rights (SDR). The SDR is a global reserve asset comprising the U.S. dollar, euro, British pound sterling and Japanese yen. China’s leadership has been pushing for the inclusion of its currency in the SDR, which recognize the yuan’s rising global status and signal to the world’s central banks that China’s domestic currency assets are a solid investment. The IMF’s senior management has said the yuan’s inclusion in the SDR is a matter of when, not if.
After some initial uneasiness in global markets following the devaluation, an element of calm seems to have returned for the time being, as China’s central bank has stated on several occasions that it has no intention of creating a large swing in the currency. The last thing the Chinese authorities want to see is for the currency to get out control and jeopardize their credibility, which has already been hurt during frantic efforts to gain a handle on the recent near-meltdown of the country’s equity market.
At the moment, market participants seem inclined to give China’s central bank the benefit of the doubt, with indicators suggesting that the yuan will weaken between 4 and 5 percent against the dollar in the next 12 months. However, the yuan is likely to experience periodic volatility, particularly as carry trades – a strategy in which investors borrow money at a low interest rate in order to invest in an asset that is likely to provide a higher return – in dollar/yuan are unwound. This could push the dollar/yuan rate higher, and, together with expectations being reset, should result in a steeper dollar/yuan forward curve than before.
As for the impact on the world more broadly, a moderately weaker yuan will create a disinflationary impulse, and, all else remaining equal, will tighten monetary conditions in many important economies. Open/trade dependent economies, like Korea and Taiwan, where the yuan is a significant part of their trade-weighted currency basket, will be more affected. For fixed-income markets, like Indonesia’s, that have a strong correlation with currency performance, some weakening can be expected. For fixed-income markets in developed countries, the response to downward pressure on inflation is likely to be positive, although the timing and extent of the pass-through will vary.