China's Devaluation and Skidding Stock Markets
Against the backdrop of decades of rapid growth driven by exports and investment, China is in the midst of a massive economic transition to a “new normal” of slower, more sustainable growth paired with the goal of creating a more decisive role for markets in the financial sector. As part of this shift, the nation’s central bank—the People’s Bank of China (PBOC)—moved on August 11 to revise the way the Chinese yuan-U.S. dollar exchange rate is calculated. This move triggered a 1.9 percent devaluation of the yuan, marking the currency’s largest depreciation in two decades and igniting panic in global markets.
The PBOC shifted the yuan-dollar exchange rate from following a narrow band around a daily midpoint calculation to floating in line with the previous day’s close. The yuan sank further over the next two days, at which point the PBOC stepped in to stem mounting worries over a runaway tumble, instructing state-owned banks to buy yuan and sell dollars. This dollar selloff strengthened the yuan, helping to prevent further freefall. Despite tentative stabilization, questions remain regarding the extent of the PBOC’s role in the coming weeks, given its initial stated intention of stepping away from currency intervention.
The PBOC’s devaluation was notable for its timing, coming just after the release of slack July export numbers (falling 8.4 percent year-on-year) and August manufacturing data (sinking to a six-year low), which heightened concerns over the trajectory of the Chinese economy. This unexpected weakening of the yuan helpfully bolsters Chinese exports at the same time that it serves the stated goal of adhering more closely to market value, which has prompted many to classify it as a measure to prop up the economy. Notably, even with its slide, the yuan remains substantially stronger than its trading partners’ currencies compared to a year ago.
Another motivator for bringing the stage-managed currency closer to its market value is China’s growing interest in adding the yuan to the International Monetary Fund’s Special Drawing Rights basket of reserve currencies, which currently includes the U.S. dollar, the British pound, the euro, and the Japanese yen. In April, the IMF declared the yuan fairly valued, though more recently it criticized the government for aggressively interfering in the currency.
Despite official statements regarding the motivation for this technical devaluation, China’s actions have intensified global economic concerns. Since this policy shift, stock markets in the United States, Europe, and across the developing world have all suffered amid worries of a slowdown in China. This declining confidence comes at a time of anxiety in commodity markets about sagging Chinese demand.
An examination of the larger picture reveals instability in China’s domestic markets—the August stock market panic followed another bout earlier this summer. After rapid appreciation over the past year, concern arose over the sustainability of the gains. Subsequently, the government tightened regulations on leveraged investing, which sent the market tumbling on the first day of the BRICS Summit in early July. Stability followed that intervention until mid-August, when the market again fell (though it remains up year-on-year, as seen in the charts). On August 23, China’s State Council approved measures allowing the state pension fund to invest up to 30 percent of its assets in domestic stocks, but the move did little to ease concerns.
The PBOC later reduced the one-year benchmark bank lending rate by 25 basis points to 4.6 percent and the required reserve ratio by 50 basis points to 18 percent to counter capital outflows, which were worsened by the yuan devaluation. Markets, however, remained unstable, and volatility continued into September with the release of declining Chinese manufacturing numbers.
Although China’s drastic market shifts caused global jitters, it is important to note that Chinese equities are not accurate barometers of overall economic health — due largely to low participation by the Chinese populace and underdeveloped corporate governance. Indeed, many view this latest panic as a needed correction that doesn’t necessarily indicate underlying weakness. At the same time, state media has increasingly encouraged wider market participation, which now closely ties Communist Party credibility to the stock market’s long-term performance. How and whether the government intervenes in the stock and currency markets in the coming months will provide valuable clues to its level of commitment to putting markets at the center of its financial system.