The latest drop of the Chinese yuan sparked renewed fears of an abrupt devaluation episode amidst a massive capital flight from China. Even though this is a real risk, it still has a relatively low probability of materializing. Rather, the most probable outcome for the foreseeable future will be an ongoing controlled devaluation of the yuan (NYSEARCA:CYB), similar to the previous ones. This assertion stems from the need to fix the Chinese distortions without triggering a domestic collapse. In order to achieve that, China will need to match its domestic rebalancing efforts with an accommodative exchange rate policy, i.e. a weakening yuan. Ironically, though, the US would also prefer a weak yuan policy so that more and more Chinese surpluses can continue to be funneled towards the ballooning US public debt market. That's the reason that the US and other debtor nations haven't loudly opposed to the yuan devaluation. Under such light, investors should brace themselves for lower yuan rates along the way, and hope that Chinese export earnings remain enough to feed the western excess consumption.
Why China Needs and Pursues a Controlled Devaluation
China is hugely dependent on its currency devaluation policy for numerous reasons. For one, it has been desperately trying to address the non-performing loans (NFLs) of its state-owned enterprises (SOEs), as well as other privately held companies. While at the same time, the authorities wish to contain the real estate bubble, evident in a lot of metropolitan areas. For all these efforts to bear fruits PBoC must tighten lending standards and reduce the growth rate of domestic money supply, among other initiatives.
By implementing such a tightening monetary policy, PBoC will risk stifling the Chinese business cycle, just when it is trying to reverse its prolonged soft landing phase. It is precisely why the Chinese authorities need to counteract all these negative effect with fiscal or foreign exchange stimuli. A fiscal stimulus would need more time to impact the economy and could also risk inflating some domestic bubbles even further. This leaves the foreign exchange route as the most efficient way to go, since it has a more direct and faster impact on the Chinese corporate world.
US in Need of a Cheaper Yuan
This "stealth" yuan devaluation is not only welcomed by China but by the US as well. The US faces its own domestic hurdles, trapped in an endless low-growth recovery cycle, and its only hope is to get some assistance from abroad. This assistance must come in two forms. Firstly, the global economy must accelerate and secondly foreign demand for US debt must continue. As far as the global economy goes, China, and by extension Asia, is the only region which could currently re-kindle the global business cycle something that would greatly benefit the US economy. This would also fuel inflation expectations across the world. A policy of controlled but steady yuan devaluation could attain that goal. Chinese managers would feel more confident to spend and produce, which in essence would allow the local economy to accelerate. An accelerated Chinese economy, would, in turn, increase inflationary and growth expectations across the globe and would certainly benefit the US down the line. Such a development would facilitate rate normalization by the Fed, making it easier for it to move forward with its next rate hikes.
The weaker yuan will also assist in boosting Chinese exports and provide more money for investments abroad. The first in line to benefit from such surpluses is the US Treasuries market, with China being the single biggest buyer. The US will certainly need its strong Chinese ally to provide buying support especially when the time comes for it to increase its debt ceiling - probably in the coming months - and thus increase the issuance of public debt. In order for the trade surpluses to widen as needed, the yuan will need to be devalued, even more so in case the current commodity rebound extends. China is the biggest consumer in the world for a lot of basic commodities. A generalized commodities rally would certainly weigh on its trade and current account surpluses, because it would make raw material imports more expensive. This would reduce, in turn, the available surpluses to invest in US Treasuries. In such a scenario, the US would witness reduced demand for its debt at time that it needs it most.
In order for the global capital flows to keep balancing out the deficits of the western nations with the surpluses of the emerging economies, the Chinese yuan should continue to weaken in a controlled environment for as long as it needs. Everyone's hope is that such a policy action can succeed in restoring global economic order, without making investors lose their faith in the Chinese economy and thus spark a massive capital exodus. PBoC has no other choice but to continue pursuing this balancing act, until China and the rest of the world find their footing again. Investors should definitely hope for its success. After all, the alternative path is too painful for the world to bear; an abrupt massive yuan devaluation can cause the biggest depression in history.
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