By Valentijn van Nieuwenhuijzen, Head of Multi-Asset at NN Investment Partners
Talk about a currency war, doubts about Chinese policymakers’ credibility and worries over the Chinese economic slowdown and its ripple effects have ignited risk aversion among investors. Yet to call the engineered devaluation by the People’s Bank of China (PBoC) dramatic seems harsh, as the yuan has since depreciated by only around 4 percent. Switzerland’s decision to end the Swiss franc’s cap with the euro in January this year, for example, caused its currency to rise by more than 19 percent. Markets nevertheless reacted dramatically.
There has been a lot of 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 percent nominal decline of the yuan has little impact in terms of real effective exchange rates. According to the Bank of International Settlements, the yuan is about 32 percent overvalued compared to its trading partners and the most expensive among 60 countries (if Venezuela is excluded). In comparison, both India and Indonesia are undervalued by about 10 percent.
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. Since the move, the yuan spot rate has been quite steady around 6.40 versus the US dollar. The Chinese authorities have a clear interest in keeping the pace of depreciation moderate. 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.
We think 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. 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.
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 which can be labelled as managed deleveraging/financial sector liberalisation. 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 Fed’s 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 last year, China has seen persistent capital outflows which means that the PBoC has had to intervene to maintain a stable dollar-yuan exchange rate. Even though there is still a very big war chest in the form of FX reserves left to stabilise the currency, the ability to do so is clearly not infinite.
In the medium to longer term China’s currency move is a positive development as it reduces the inconsistencies in the aforementioned policy objectives. However, the consequences for the short term are more uncertain. 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 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.
In 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 Fed.
According to the CME Group’s FedWatch calculator, the probability of a September hike has declined to 21 percent and the likelihood of a December increase to 48 percent. Should global risk appetite show signs of life again in the coming weeks, we still believe the 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 stop the Fed from doing so.
