Turmoil in Global Markets: China’s Currency Devaluation
China’s policymakers devalued the yuan on Tuesday, and it dropped nearly 3% over the past two trading days. Those policymakers stated their reason publically: it was done to allow the yuan to float more freely against other currencies. Analysts are concerned that the bigger story may be China’s deteriorating economic growth. Although Tuesday’s decline was the largest in China’s history, it should not have been entirely unexpected: the China State Council announced on July 23 that it would allow the yuan to trade in a wider band against the dollar.
The analysts may be right—China’s growth is slowing. Weak domestic investment coupled with slowing global demand, particularly in the Eurozone, are threatening China’s 7% gross domestic product (GDP) target. In addition, China’s exports have declined 8.9% for the year ended July 31, well below expectations. By devaluing the yuan, China’s policymakers hope to boost factory orders and support exports, since goods denominated in their currency will be more attractive to global buyers. But some analysts suggest the yuan will need to depreciate even further to halt the decline in exports.
Another concern is the widespread skepticism regarding the official data released by China. Analysts have long questioned the reliability of the government’s numbers. Although that skepticism may extend to whether there is reliability in what the policymakers are saying, China’s move is not exactly a “nuclear option”. Were there really an economic panic, China likely would have imposed capital controls, which it has not done. Only time will tell whether or not their “official” story is accurate. If the yuan continues to weaken to double-digit declines, it will be obvious something is wrong. China values stability, and it remains to be seen whether it is considering the potential unintended consequences of global dislocations tied to its actions.
There also may be external rationales that drove China’s decision to devalue its currency. Because higher interest rates generally lead to a stronger currency as investors seek higher yield, the highly anticipated Federal Reserve move to raise rates will put upward pressure on the dollar, and in turn, the yuan. A stronger yuan will exacerbate the problem of China’s weak exports. Taking this extraordinary currency devaluation step ahead of the Fed action helps China maintain some flexibility.
The yuan had been pegged close to 6.20 to the U.S. dollar, in a push for China to be included in the International Monetary Fund’s (IMF’s) list of reserve currencies. The IMF recently indicated it would like to see China implement additional capital market reforms, including exchange rate flexibility. Devaluating its currency may be a step in that direction. Essentially, China is allowing its currency to weaken in the short term in order for it to be more valuable in the long term.
One more factor to consider: the Chinese government has been on a multi-year attempt to shift its economy away from heavy reliance on exports and state-spending on infrastructure and towards a more balanced, consumer-driven system. That transition will take years if it succeeds, and in the interim, it is almost certain that headline growth will decrease. Over time, however, the new mix of consumer-driven growth and the improved quality of economic activity may be more conducive to China’s prosperity and stability than exports and capital spending as the primary pillars.
Conclusion: The Impact It Has for Advisors and Their Clients
Possible currency contagion: An overarching concern is that China’s action may lead to a more widespread currency contagion, similar to what we experienced in 1997 during the Asian Financial Crisis. That year, Thailand was forced to allow its baht (which had been pegged to the U.S. dollar) to float, as it could no longer support the fixed exchange rate. The baht plunged, with other Asian currencies quickly following suit. The result was a steep decline in stock and other asset prices. Several Asian countries, including Japan, Taiwan, and Korea, have long favored weaker currencies. They may perceive China’s action as a competitive devaluation, leading them to devalue their currencies, as well.
Increased volatility: Investors can anticipate almost certain volatility, as they weigh Fed action, which has been highly anticipated to begin in September. However, with the reality of China’s currency devaluation, coupled with sluggish U.S. economic growth, investors could conclude that the Fed may postpone a rate increase until December. Markets tend not to react well to uncertainty.
Potentially lower equity prices: Equities in general are entering a historically soft—and volatile—seasonal period through October. In addition, there has not been a correction of more than 10% for nearly four years. The S&P 500 Index is down -3.5% from its closing high on May 21.
Widening credit spreads: Credit spreads have widened, in the wake of underperformance of high-yield bonds.
Pressure on emerging markets: Weak currencies will put pressure on emerging markets stocks. Currency devaluation hurts that country’s stock prices, as investors seek higher-yielding assets elsewhere. But it’s important to maintain perspective: although prices for Chinese equities have dropped 25% from their peak on June 12, the country’s Shanghai Composite is still up more than 20% year to date, and up more than 80% over the past 16 months.
Focus on quality: Turbulent environments tend to favor active managers, particularly those whose investment process emphasizes companies with the financial strength to weather the storm. History can also be a guide here: during the Asian Financial Crisis, the quality factor delivered strong relative performance.