On Aug. 11, the world’s second-largest economy roiled markets by allowing a more market-driven exchange rate mechanism to determine the value of the yuan. The result was a 3.4 percent plunge against the dollar, the largest two-day slide in more than two decades.
The move by the People’s Bank of China (PBoC) came as a shock, causing panic in global markets. In an effort to combat the precipitous drop and stabilize the yuan, the PBoC tripled the amount of cash injected in the financial system in its open-market operation the following week.
Based on the economic data coming out of China, depreciation of the yuan should not be that surprising. Policymakers’ efforts to stimulate the economy by cutting interest rates, lowering bank reserve requirements and propping up the stock market have not delivered the desired result. Chinese exports have been on a downward trajectory, dropping 8.3 percent in July. Meanwhile, as a result of the de facto peg against the U.S. dollar, the yuan had appreciated 13 percent in the last year on a real trade-weighted basis. In the end, PBoC gave in to pressures to weaken the currency to boost demand.
It is also believed that depreciation of the yuan was an attempt by Chinese policymakers to improve its case for obtaining reserve currency status from the International Monetary Fund. During its last review in 2010, the Washington-based fund rejected China’s bid for inclusion in the Special Drawing Rights basket of currencies on the basis that the yuan was not “freely usable.”
In light of the public condemnation of China’s actions, it is worth noting that China is not the only country that has embarked on monetary quantitative easing programs. The U.S., Japan and the European Central Bank have all been down that road, and China is just the latest country to join the party.
In reality, the yuan’s depreciation was trivial when compared to the depreciation other emerging-market currencies have experienced this year. Perhaps investors are more worried about the distress signal this move sends about the future growth prospects for China and the rest of the world. In effect, the actions of the PBoC can be seen as confirmation of slowing economic growth in Asia’s largest economy, and the implications for the rest of the world are alarming.
Emerging-market assets have been the hardest hit as China’s slowdown spurs further commodity price declines. As the world’s largest consumer of commodities and metals, China’s decreased demand is to the detriment of commodity producing countries like Brazil and Australia, as well as China’s Asian trading partners.
European export-led economies like Germany, with significant exports to China and other emerging markets, also face headwinds. Not only would one expect exports to China to decline, but devaluation of the yuan also makes Germany and other export-based economies less competitive.
Companies that derive considerable revenue from mainland China will be adversely affected by a lower yuan. This includes semiconductor companies like Marvel Tech, Qualcomm and Texas Instruments, as well as restaurant operator Yum Brands, all of which generate more than 40 percent of revenue in China.
Chinese companies that have issued USD and Euro denominated debt may face additional challenges as their debt servicing costs rise. According to Bloomberg compiled data, Chinese companies have $529 billion in such loans and bonds outstanding. As such, concerns of rising company defaults are certainly warranted.
Clearly a lower yuan is advantageous for Chinese exporters as they try to regain competitiveness. Likewise, Americans and other foreign consumers also reap the benefits of cheaper Chinese goods. Moreover, U.S. companies that source from China can now do so at lower costs. Admittedly, U.S. exports to China will suffer, but U.S. total imports from China trump exports by a ratio of 2.9 to 1.
Although a lower yuan is by and large positive for China’s exports, the minor devaluation in August is unlikely to boost exports substantially. Similarly, the impact on importers of Chinese goods is not material. Still, now that China has taken the first step toward a more liberalized exchange rate, and as the yuan continues to experience downward pressure, further depreciation is highly probable. On the other hand, substantial devaluation is not expected, as this would be counterproductive and jeopardize the country’s chances in obtaining reserve currency status.
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.