This is just the beginning of a very dangerous game in China

China has devalued its currency, the yuan, by 2%.

In a statement, the People’s Bank of China said that it would now allow the yuan to float closer to a market rate. It had been pegged to the dollar.

This is the beginning of a dangerous game.

The devaluation of the yuan is likely to lead to capital flight, as investors withdraw their money from the country in expectation of further falls in the currency.

And the falling yuan also adds to the debt pile of some of the most indebted companies in the country, as the devaluation makes interest payments on debt denominated in foreign currencies more expensive. 

A country only takes those kinds of risks if it knows it’s in a precarious situation.

China devalued the yuan after watching its exports crater over 8.9% in July from the same time last year.

That is in part because the yuan has been tied to a strengthening US dollar, and in part because wages inside the country are increasing.

Those two factors combine to make exports more expensive, and therefore less attractive to foreign buyers.

The thing is, China wants wages to increase. For years it has been trying to move its economy from one based on exports and foreign investment, to one based on domestic consumption.

So wage growth is good, as China wants its people to have the purchasing power to keep the economy afloat on their own.

Right now that isn’t the case, though. Services/consumption only account for 49.5% of GDP, compared with around 43.7% for industry, according to Bank of America Merrill Lynch.

That means China has a way to go before it gets to where it wants to be. With this devaluation, it has offset the increasing wage growth with a cheaper currency, in effect buying itself some time to get the economy from where it is today to where it needs to be. 

The devaluation comes with strings as heavy as chains however.

Let it float

The primary risk is that the devaluation leads to capital flight. 

China still has to keep its economy going, and it needs capital to do that. But with a devalued yuan, money will certainly leave the country as people fear their cash will continue to lose value.

“The risk is that depreciation triggers capital flight, dealing a blow to the stability of China’s financial system,” wrote Bloomberg economist Tom Orlik in a note after the PBOC’s announcement. “Our calculation is that a 1 per cent yuan depreciation against the dollar triggers about $US40 billion in capital flight.”

So China has to do this slowly, monitoring the capital flight situation to ensure that money doesn’t leave the country too quickly and suck up liquidity. Analysts have been expecting the country to cut rates this fall, but it’s already done that four times since November. Clearly the PBOC didn’t think that policy measure would do enough.

There are also signs that the currency is going to have fall further in value. 

Here’s how the currency has worked in China. There are two values — one is the onshore value of yuan (which was just devalued by 2%) and then there is the offshore value of the yuan, which tends to float more freely according to the currency’s fair market value.

Right now, the offshore value of the yuan is still lower than the value of the on shore yuan. This indicates that the currency still hasn’t hit fair market value.  

Protect this house

There’s another thing to take into consideration; the indebted state of China’s corporate sector. Devaluing the yuan only makes the dollar- and euro-denominated debt these companies are holding more onerous. According to Bloomberg, it adds $US10 billion to their $US529 billion debt burden.

What’s more, a lot of that debt is located in China’s oh-so-crucial property development sector, which has already seen some defaults this year.

From Bloomberg:

“Chinese property developers have lots of offshore debt outstanding — more than 20 per cent of their total debt for some — and the majority of them have high leverage and weak cash flow,” said Christopher Lee, managing director of corporate ratings for Greater China at Standard & Poor’s in Hong Kong. “If the yuan depreciation sustains, they will face pressure on servicing their debt.”

And that could mean more defaults. More precarious situations thanks to a government playing a precarious game.

 

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