The Yuan Devaluation: Unexpected But Economically Sensible

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Includes: ASHR, CNY, CYB, FXCH
by: David Kotok

August 10th's announcement by China that it would "devalue" the yuan (also called the renminbi), caught markets and us by surprise as China had been keeping its currency within a narrow 2% band against the US dollar during the past year. China followed this managed float system to maintain stability, to encourage consumption, and to lessen capital outflows. However, with the continued upward trend in the US dollar against most other currencies and the slowing of China's economy, China's central bank, the People's Bank of China (PBOC), has had to constantly counter depreciation pressures as the gap between the government's rate for the yuan and the external market rate widened.

The yuan's devaluation on Tuesday was 1.9%, followed by a further 1.6% on Wednesday, a day which saw the PBOC intervene heavily in the final hour of trading to support the currency from falling further. At the end of the week, the onshore, or official, rate for the yuan was down 2.8% for the week. The PBOC explained in an unusual press conference that, "From the international and domestic economic and financial situation, we can see that there is no basis right now for continued depreciation of the renminbi (yuan) exchange rate." They had announced earlier that they were moving to a more "market-based" exchange-rate system.

The new system, which is somewhat of a black box at present, continues to be a form of managed float. What is new is that the PBOC now sets the official rate, or "fixing," based on the currency's closing level in the previous trading session. We understand that a number of banks submit closing prices to the PBOC, which are used for the calculation. Before, the rate set by the PBOC could differ from the previous day's market signals. The change does appear to be a significant move towards market determination. The IMF called it "a welcome step as it should allow market forces to have a greater role in determining the exchange rate." The US Treasury also welcomed the move.

Global markets did not expect this development and over-reacted badly until the PBOC, through its statements and actions, eased concerns later in the week. One concern was that the Chinese move would turn out to be the first shot in a protracted currency war. Central banks in the region had a better understanding of the nature and dimensions of the move and did not react strongly. As noted above, the PBOC made clear that their objective was a limited one. Many commentators said the move by China had the objective of countering the recent poor export data, but if that were the motive, a much larger devaluation would be the answer. The impact of this devaluation on trade will be very small.

Another reason many gave for the strong market reaction was a concern that the Chinese government feared the economy was headed for a more significant slowdown than was already built into the market. Again, if that had been the government's motive, a more aggressive currency move would have been called for. It is true that some recent activity data for July fell below market expectations: there was slower growth in July compared with June in industrial production, fixed-asset investment, and retail sales. But any slowdown this quarter is likely to be modest, not dramatic.

Furthermore, some argued that the Chinese devaluation might cause the Federal Reserve to delay the policy interest rate increase that seems most likely to occur in September. A delay is possible, but it is unlikely that the modest devaluation of the yuan will be a factor. The strong dollar is a negative consideration for the Fed's going forward with the rate move in September, but the additional pressure coming from the yuan devaluation will be small.

The Chinese continue to have several good reasons to avoid a more significant devaluation of their currency. Along with their desire to maintain stability and to avoid the negative effects on consumption that would come from a weaker currency, the most important reason is probably their wish to limit capital outflows, which are already a concern. We think the PBOC will support the yuan when needed in order to prevent significant further weakening.

Therefore, we do not see this week's currency actions by the PBOC as a significant cause for concern for global markets. We do note that some Chinese firms have issued large amounts of high-yield US dollar bonds. These firms will have to meet their dollar interest payments out of income that is largely in a currency that has depreciated in value. Other Chinese firms will benefit from a very modest increase in the international competitiveness of their products. Effects will vary depending on the extent to which costs and incomes are in yuan versus US dollars.

In contrast to the sharply negative reactions of global markets, the Shanghai market gained nearly 6% this week. The Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR) gained almost 3%, the difference being the effect of the yuan depreciation on US dollar returns.