Last month, the world watched a spectacular crash in the Chinese stock market, in which 30% of the value of shares was wiped out in a matter of weeks.
The government unleashed an astonishing array of measures to try and stop share prices sliding. Authorities started by allowing huge financial institutions like insurance companies to increase their exposure to stocks – effectively ordering them to buy shares to support prices. Then came orders for companies to stop trading, and finally there were threats of arrests for people caught selling stocks. The bleeding stopped, but only after the stock market was practically shut down.
This month, China has stunned the financial world again, by changing a long-standing policy that meant its currency remained relatively stable in its exchange rate against the US dollar.
The devaluation of China’s currency – whose name we’ll get to shortly – may not seem like much, because it was just under 2% on Tuesday. But it came with an important change in policy which means the currency is likely to be more forcefully determined by the judgement of global financial markets.
So far, the moves have only been small but China is such a large part of the global economy now that changing how it treats its currency has potentially huge ramifications for businesses and consumers everywhere. This is why people are watching it with such interest.
We’ve set ourselves the task of explaining what’s happening with the currency and why China has taken this step of allowing market forces to play such an important role in setting the value of the Yuan, so soon after the recent battle over share prices..
There are potential and real consequences for the global economy and markets that result from the new currency regime, and we’ll explore those as well.
First, China’s currency has two names and trades at different exchange rates.
We explored this back in 2014 and the best explanation remains the ECRI’s 2011 ready reckoner:
China’s currency is officially called the renminbi. The yuan is the unit of account. The renminbi, denoted RMB, is thus the name for the currency traded onshore and offshore. There exists a separation between these two markets, as China institutes capital controls that prevent the currency from flowing abroad and vice versa.
If the RMB is traded onshore (in mainland China), it is referred to as CNY, whereas if the RMB is traded offshore (mainly in Hong Kong) it trades at the rate of USD/CNH, deliverable RMB located in Hong Kong. Thus, while the RMB is just one currency, it trades at two different exchange rates, depending on where it is traded.
Some strategists will just call the currency the Renminbi, while others will refer to the CNH and CNY. When you read Renminbi, or RMB, just think overall currency level without the nuances of whether it is trading onshore or offshore.
Currency value is a powerful economic lever in any nation, and China’s economy is weakening.
The combination of official interest rates and the traded price of a nation’s currency set the monetary conditions within an economy.
All other things equal, when a currency rises against its trading partners or competitors, the sectors of the economy exposed to that rise lose competitiveness, partly as its exports become more expensive. When a currency falls relative to trading partners and competitors local businesses who either export or compete with imports become more competitive.
That’s why central banks of small open economies like Australia and New Zealand like to let their currencies float. They believe the currency movements are the other arm to monetary policy and thus help regulate the economic stimulus in the economy. The more open the economy, the greater the impact of currency movements on economic growth.
It’s no different for larger economies either. Japan all but debased the Yen as Abenomics drove the exchange rate with the US dollar from just under 80 in September 2012 to the recent high around 125 – a move of 56%.
The US dollar weakened materially in the aftermath of the GFC. That helped provide a boost to economic growth in the US by making local producers more competitive to customers, both at home in the US and abroad.
So, with China’s economy still dominated by investment in fixed capital along with the export and import of goods and services (which on 2014 estimates equate to roughly 22% and 24% respectively of GDP) the recent strength of the RMB relative to other key currencies has hurt economic growth.
Flows of money have hurt China, too.
Societe Generale Economist Albert Edwards says that this has meant that this has been a dramatic change because over the last 18 months China has had a “huge swing into a Balance of Payments deficit.”
The balance of payments (BOP) is simply a calculation of all the trade conducted in the economy by the private sector as well as the government sector and associated businesses to determine whether money is flowing into or out of an economy.
Because China has swung into a BOP deficit Edwards says that means there has been “chronic downward pressure on the renminbi, forcing the Peoples Bank of China (PBoC) to start selling its vast foreign exchange reserves to prop up the beleaguered currency (FX reserves have slid $300bn over the last four quarters)”.
This means the PBoC was buying its own currency – not from a position of acute weakness, as we have often seen in Asia, Russia and at times Australia, but from a position of relative strength.
That is counter productive for economic growth if it is slowing as it makes Chinese business and industry less competitive by keeping the RMB higher than it otherwise would be.
Edwards said that left the Chinese currency “substantially overvalued, especially with the rest of Asia devaluing alongside the Japanese yen. The most shocking illustration of China’s loss of competitiveness in recent years is the 50% surge in its Real Effective Exchange Rate (REER) against the US.” This basically means the currency has been surging in value against the US dollar, and is illustrated in the chart below.
Devaluation became inevitable as a result.
That set up an untenable situation for Chinese authorities, who were effectively being forced to buying RMB onshore (CNY) to prop up the price when the flow of funds and market forces in offshore trade (CNH), were exerting significant downward force on the level of the currency.
That meant a significant gap opened up between the onshore market, which the PBOC regulates, and the offshore market where market forces hold a greater sway and the CNH can float more freely.
Christy Tan, the NAB’s head of markets strategy and research in Asia, wrote this week that the decision by the PBoC to move on Tuesday and then allow further depreciation over the following two days was because “China delivered its commitment to close the gap between daily fix and market levels.”
There’s a short game and a more important long game.
Tan also said that the PBoC is running two “timelines”.
The short term objective is “one-time correction to close the gap between the central-parity rate and the market rate.” This has been met again today and the PBoC will probably be consistent on this in coming sessions. For the medium term, the PBoC will allow the market to play a bigger role in setting the exchange rate “to facilitate the balancing of international payments.”
The balancing of international payments is what Albert Edwards pointed to as a source of concern.
But the PBoC’s commitment to letting market forces set the RMB rate was tested in just the second day of the new regime, with reported intervention on behalf of the PBOC to slow the CNY’s weakness in trade.
That drove the exchange rate against the dollar from 6.4486 to close at 6.385. But this morning in letting the currency fix lower again at 6.4010 the PBOC signalled that it is still listening to the signals from the market.
Financial markets are in a funk about this because traders hate uncertainty.
The surprise move by the Chinese to both devalue on Tuesday and the associated regime change that has seen the RMB continue to weaken in onshore and offshore markets created ructions in global stock, bond, commodity, and foreign exchange markets.
Traders hate uncertainty and in letting the RMB slip anchor, the PBOC has awakened some real fear among global investors, traders and strategists that because the global economy is still fragile this move could be the proverbial straw that breaks the camel’s back.
The weaker Chinese currency could hurt emerging Asian nations.
As case in point is Soc Gen’s Edwards who has dialled up the rhetoric, saying the move by the Chinese this week raises fears of a 2008 style market rout.
China’s need to become more competitive can also hurt its neighbours, and Beijing’s moves will put pressure on the already fragile emerging Asian economies.
Edwards, and many other commentators, believe that the devaluation – because of the potential for a downward competitive spiral of the region’s currencies – will unleash a new wave of global deflation. They believe that China has joined the currency wars.
Others simply think that the move this week is a reaction to external forces and thus will have less impact. Certainly the move appears to have been catalysed by the terrible export data for July released on Saturday, and as such could be proof many investors were seeking that the Chinese economy is much weaker than the official figures suggest.
But, while these concerns are valid and the risk of another deflationary pulse is real, this week’s market ructions were more likely a result of the very simple fact that markets just hate a shock.
That’s because traders get caught on the wrong side of the market. They have to liquidate positions, they need to sell assets in the money to pay for the losses. They hate losing money, and hate being wrong even more.
And this move by the PBOC was a massive shock because it caught markets on the hop.
However, the positive impacts of this medium term strategy can outweigh the near term risks.
Not everyone believes that this move this week is bad news. China has sat by while the countries around them, their competitors and their customers, have seen their currencies slide. That’s made China less competitive and more expensive to do business with, while it’s made these customers and competitors more attractive for others to do business with and other markets cheaper.
That’s hurt China and it’s hurt Chinese growth.
Fears of competitive devaluations as nations race to weaken their currencies are potentially well-founded, but unlikely to come to fruition according to Capital Economics economist David Rees.
Rees said today that regardless of near term risks to further weakness:
We do not expect recent moves to turn into a rout. For a start, if the PBoC is going to allow the market to play a greater role in determining the renminbi’s exchange rate against the dollar, we do not think it will be long until sentiment starts to improve as signs emerge that the economy is stabilising.
In addition, currencies have generally depreciated by 10% or more against renminbi in the past year owing to the latter’s recent de facto peg against the dollar. As such, the renminbi has only been playing catch up and there is unlikely to be much impact on China’s demand for exports from other EMs as its economy improves. It is a similar story for commodities, whose prices are already much lower than a year ago and are unlikely to continue to slump.
That, Rees says, means the “upshot is that once the renminbi sell-off eases, there is room for EM markets to rebound.”
This is still so significant that China could force a delay to the moment global markets have been waiting for – a return to interest rate rises by the U.S. Federal Reserve.
Unlike China’s surprise move this week the Fed has telegraphed well in advance its intention to raise rates sometime this year. Just this week Atlanta Fed President Dennis Lockhart reiterated that September was in play.
But it’s the words of Fed Vice Chair Stanley Fischer that are ringing in the ears of bond and currency traders. Earlier this week, Fischer told Bloomberg that “Employment has been rising pretty fast relative to previous performance, and yet inflation is very low.” Traders believe that implies the Fed still has enough concern about the low level of inflation in the US to possibly delay the first tightening.
That has seen Fed funds futures probability of a September hike fall to 40% overnight from 70% last week. The US dollar was also sold heavily as a result as traders readjust their bets.
China hasn’t broken any rules, or done anything wrong.
A country’s currency is the most important transfer price in the economy. If, as China is, you are an open economy with a large reliance on trade for economic growth then, as we have highlighted above, the level of your currency is important for accelerating, or slowing, economic growth.
As David Rees highlights all China is doing is letting its currency catch up to many of the other market-based currency moves. If China wasn’t running a managed currency regime, then arguably market forces would have driven the RMB substantially lower as soon of the whiff of economic weakness emerged.
This week’s realignment simply recognises that.
In fact, China has been a strong global citizen through years of economic turmoil.
It is worth highlighting that China has been a fine global citizen during the acute period of the GFC, where they held their currency stable, and since then when they allowed the RMB to be fairly strong on a global basis.
Equally, for those characterising this as China joining a global currency war, reference must be made to the price action of the USDCNY rate over the past 12 months against the massive depreciations of the Aussie dollar, Euro and Yen. It makes for an interesting graphic.
As David Scutt wrote earlier today, the chart “suggests the hysterics over the yuan’s devaluation may be slightly misplaced.”
Indeed, perhaps more than slightly.
Likewise Allianz’s Mohamed El-Erian told Business Insider that China has made the right move, just perhaps at the wrong time.
As part of its efforts to navigate its tricky “middle income” development transition, China is taking an important step towards a more determined market-based system for exchange rate determination.
It is a step that others have been urging for a while (thus the generally supportive comments out of the International Monetary Fund and the US Treasury). And it is one that, over time, would serve longer-term global economic stability, including more-timely rebalancing.
El-Erian cuts to the core of the current reaction about China emanating which is essentially one which says “what you have done doesn’t suit us”.
But, as EL-Erian points out, it suits China.
Beijing is now looking after Number One.
China is the world’s second largest economy. Rather than an open, market-based economy, it is planned economy with market leanings to support the growth aspirations of its people. China has a population of almost 1.4 billion people, almost all of who look to the Chinese Communist Party to put the framework in place for their lives. Beijing understands that in fulfilling this compact with their population for growth, jobs and improved quality of life they will retain their authority within the Chinese political system.
As fanciful as that may sound, the lesson of history is there is nothing like poverty to drive regime change.
So, the core lesson here is suits China. China’s neighbours in the South China Sea have been learning that this is how the country is behaving and it’s something that international markets are going to have to get used to as well.
China is emerging, and internationalising its markets. It’s been doing that since 2001 when it joined the World Trade Organisation. In that time its growth has been impressive and it has been a positive force for the global economy.
China’s internationalisation is continuing but that for the moment at least, it is taking steps that will bolster its own economic growth profile.
It’s been an uncomfortable week. But measures to manage China’s economic growth are also good for the health of the global economy.
The big question is whether all this action by Beijing will eventually be enough.