Overnight the People’s Bank of China (PBoC) surprised markets by dropping the daily reference rate for the renminbi by 1.9%, effectively announcing a devaluation of the Chinese currency. The move is the biggest daily drop in the currency since 1994, and reverses a long period of appreciation that started in 2005. Initial market reaction has been somewhat muted, but the shape of price action suggests investors see the development as broadly deflationary for the global economy. Emerging market (EM) and commodity currencies have weakened, Asian currencies have dropped, equities globally are modestly lower, and government bonds have rallied. Commodities are mixed.
Zero-sum game
With regard to its impact on growth, it feels at best like this is a zero-sum game: what is good for growth in China is unfortunately bad news for everybody else. This is certainly not a reflationary move that benefits all. For that reason, it is no surprise that equities and currencies are weaker in many parts of Asia, particularly in export-orientated economies that compete with or export to China. For global inflation, the effect is likely to be negative as lower manufactured goods prices and lower commodity prices feed existing downwards pressures. That suggests another negative pulse for EMs, but nominal government bonds should benefit. The devaluation and associated knock-on effects further complicates US monetary policy, but with data for the domestic economy continuing to encourage the Federal Reserve to tighten this year, it may take more than this to derail the start of a tightening cycle. The implication is that the EMs might face a double-hit from US monetary headwinds and China driven demand destruction.
Debt in doubt
Another consideration is the impact of the depreciation on Chinese companies. Chinese corporates have issued a significant amount of debt in recent years, a great deal of which is denominated in US dollars. Markets have assumed that the Chinese authorities are inclined to keep the renminbi pegged to the dollar to make the servicing and repayment of the debt easier. The PBoC’s move to devalue China’s currency casts doubt on such assumptions, and ups the pressure on already-stretched corporate balance sheets. Companies in other EMs may also have to live with heightened financial risks. All in all, it is hard not to view this development as one that increases systemic risks in EM.
More to come?
Of course, the currency decision becomes more significant if it presages further moves to come. At this stage, no-one can be certain of whether this is the beginning of a bigger depreciation. Some commentators have observed that if the market were allowed to determine the level of the Chinese currency, its recent behaviour suggests it would try and push it lower. That may not be to the liking of the PBoC, which can intervene to push back. However, if the Chinese authorities were to fight the market and support the currency, why loosen the reins in the first place? Make no mistake, the days and weeks ahead will be interesting ones to watch, and may have a real impact on asset prices.
Today China has weakened the renminbi (RMB) by 1.9% against the US dollar in a move to help support economic growth. The RMB has been very strong relative to other emerging market and Asian currencies in recent years and this, combined with rising costs, has been making China’s export sector increasingly uncompetitive.
Recently, the purchasing managers’ indices (PMI) survey of manufacturing activity in China has again pointed to weakness in the economy, and the devaluation move on its own is unlikely to bring any major relief to the Chinese export sector. We therefore expect further easing measures and fiscal stimulus in coming months to boost growth. China will also claim the devaluation is another step towards financial reform and flexibility in order to increase the likelihood of the RMB being included in the International Monetary Fund’s basket of global reserve currencies.
Since 2005, the RMB has been on a strengthening trend versus the US dollar and many other currencies. While the actual size of the devaluation is not a large move by global standards, (in January 2015 the Swiss franc appreciated 18.8% when its cap against the euro was scrapped) it is a major change for the mindset of Chinese corporates and investors, as well as international investors in Chinese assets.
The immediate reaction of investors today has been to focus on those companies with revenues and costs denominated in different currencies eg airlines with US dollar fuel costs and RMB revenues. But the more important impact will be watching what happens to Chinese companies with US dollar debt, especially as the US Federal Reserve may be about to raise interest rates, and monitoring investors’ views on the direction of the RMB as any expectation of further weakness may trigger capital outflows.
As the Chinese authorities like stability in times of uncertainty, it is quite possible the RMB remains stable from here but additional measures may be taken to stimulate growth.
