21 Aug 2015
The People’s Bank of China (the Chinese central bank) surprised markets last week by devaluing the currency, the renminbi. The first move on Tuesday 11 August was its biggest one day currency move since 1993, followed by two smaller moves on Wednesday 12 and Thursday 13 August.
The basis for the move appears to be linked to China’s slowing economy. The devaluation will also assist in making their exporters more competitive.
The move sent equity and currency markets into free fall, given they have become accustomed to a stable renminbi since the Asian financial crisis in 1997.
What is the renminbi and how did the central bank devalue the currency?
China’s currency, the renminbi (also known as the yuan), is managed tightly against its own basket of foreign currencies (widely suspected to predominantly be the US dollar). The central bank allows the currency to move 2% above or below the rate it sets for that day, which is called the daily fixing or reference rate.
More recently, China has let the currency float more freely, allowing the currency to rise to encourage more imports and consumer spending. In addition, China is attempting to liberalise the economy, moving the currency towards floating freely in order to achieve reserve currency status (selected by the IMF – currently USD, EURO, YEN and POUND).
Why did the central bank devalue the currency?
China’s economy has been slowing over the last couple of years. Recent efforts by the central bank to stimulate the economy have not had the same effects they had in the past. In addition, the currency has been steadily rising over the last couple of years due to market forces. At the same time, the Japanese and the Europeans have devalued their currencies through policy action such as quantitative easing.
This has made China’s exporters less competitive, thus impacting on economic growth. Only last week, China reported July exports slid 8.3% from a year earlier, reversing a gain of 2.8% in June. Imports fell for the ninth month in a row, dropping 8.1%, after a decline of 6.1% in June.
This, in addition to the sharp falls in the Chinese stock market more recently, has adversely impacted confidence and sentiment in China.
What are the implications of the currency devaluation?
The most direct impact is the increased competitiveness of Chinese exports. In addition, local Chinese businesses could benefit as the price of imports has now increased, making locally produced products more competitive. Both will boost the economy.
The indirect impacts are more complex.
One of the major concerns is the action may cause fellow Asian neighbours (Taiwan, Korea, etc.) to devalue their currencies in response, thus perpetuating a currency war. Currency wars are a zero sum game – when one country benefits, another country is disadvantaged.
The move to devalue the currency could have both positive and negative ramifications for China’s plan to liberalise their economy, whilst leaving the exchange rate to be set by market forces. China wants the IMF to include their currency in the Special Drawing Rights, a basket of reserve currencies it uses to lend to sovereign borrowers. For the currency to receive reserve status, it must be freely floating.
The move could also result in the exporting of further deflation given the still relative low costs of production in China. This is bad for developed economies given the already low levels of inflation, and given extraordinary efforts by central banks to lift inflation. This may even lead to the US central bank delaying its first rate rise until December, just as September was firming as the key date.
The devaluation hurts commodity countries like Australia and Canada, given our commodities now cost more for the Chinese to import. It also hurts luxury good exporters in Europe who export heavily into the Chinese market.
What do we think?
We definitely think the move was made to make Chinese exports more competitive in light of the significant YEN and EURO devaluations over the last year or so. We think it highlights the Chinese economy is slowing more than official figures suggest.
But we also think the move was China’s way of adopting a more market-oriented approach in its efforts to move the exchange rate to a free float.
We don’t think the US central bank will delay its first rate rise, with September still likely, followed by another rate rise in December. Though, the US central bank has recently indicated they want stronger inflation before moving rates higher.
Further currency devaluation by the People’s Bank of China should not be ruled out. We remain watchful.
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