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Question of the Week - August 24, 2015

Guest Post - Tuesday, August 25, 2015

What happened with China’s currency devaluation?

The media has certainly made an issue of this, largely because it appeared mysterious and more sudden than some expected (action at all was surprising to many). The impact was a devaluation of just under -2% in dollar terms on the first day, combined with a new ‘target,’ that turned into about a -4.5% devaluation over several days. Then, Chinese officials calmed markets by Wed. evening/Thurs. morning, announcing that the ‘re-valuation’ was generally over. Markets have generally recovered from a quick, but not severe, drop, believing this is the case. This may have seemed like a big move for a few days, for sure, but it really wasn’t in the whole scheme of broader currency trends (which can go into the double-digits for multi-month periods). It was, however, the first deliberate move of the sort by the Chinese in over 20 years.

Like many things in China, values of the yuan currency have been traditionally ‘controlled’ by the central government. For strategic purposes, the government has generally pegged the yuan to the U.S. dollar to within a certain range, with a ‘fair value’ established by the Chinese themselves. Pegs are put in place to provide the air of stability, when a currency is attached to one perceived to be more credible, but the double-edged sword is that the currency then becomes subject to the whims of the other currency’s benefits and problems. Since pegs are not formal relationships, they’re operationally kept in place through buying or selling of foreign currency reserves, so a major move in one’s own currency necessitates a lot of FX transactions to keep the peg in place on an ongoing basis. This can be not only complex but also expensive.

As a backstory, in their periodic evaluation, the IMF recently decided to not include the Chinese currency in their ‘Special Drawing Rights’ basket, which is essentially a group of premier reserve global currencies. These currencies (today, it’s the U.S. dollar, euro, Japanese yen and U.K. pound) are generally the highest-regarded and most liquid global currencies intended to hold their value during stressful periods and used as the IMF’s ‘currency’ for various activities. The Chinese would like to be part of this club, feeling it will provide them heightened global respect. The rejection was due to the dollar peg and unwillingness of the Chinese to let market forces dictate a real ‘market’ value. The U.S. has complained about this for some time, labelling China a ‘currency manipulator,’ despite the peg in place.

Due to that peg, a stronger dollar has pulled the Chinese currency up with it. In fact, according to some currency models, the Chinese currency is currently among the world’s more expensive. (Emerging market currencies have generally been weaker and more volatile than developed market ones, due to the obvious trust challenges of financial stability, political freedoms, economic might, etc.). However, now that the Chinese economy has weakened (in contrast to the direction of the U.S. economy), the Chinese thought this was as good a time as any to loosen the peg a bit and let their currency float downward—announcing that daily values would now be more determined by market forces than in the past. (However, it was implied that extreme market reactions are likely to be tempered by central bank policy to some degree to keep things orderly.) The coincidental timing of this change in policy may well have had as much to do with the IMF decision as it does a strategic devaluation—although that was a very convenient byproduct. On one hand, as China grows in economic importance, its currency could likely strengthen to reflect this might; at the same time, this can be a double-edged sword as it can negatively affect global trade.

Why would a country devalue their currency? Contrary to conventional beliefs about national power and desired currency strength, in the near-term, a weaker currency can provide an economic boost since it lowers the price of exports. This is in the best interest of most manufacturing nations—especially emerging markets that depend heavily on exports. Chinese exports fell off by -9% last month, and that concerns policymakers, who realize it’s a critical piece to their economic growth puzzle, as much as they’d like to improve their own internal consumption story. It’s important to remember that currency values are only meaningful in relative terms (dollar vs. yen, dollar vs. euro, euro vs. yen), so having a weaker currency than your neighbor is a benefit in trade, as your exported goods will look more attractive. By contrast, a stronger currency is in some ways akin to financial tightening, a la raising interest rates, in a time when a country might not want to have that happen. (You can see how the strong U.S. dollar has that effect somewhat, causing complications in monetary policy.)

And that is the gist of it. The other problem that gets involved with currency policy changes like this is central bank/government credibility. If a country has vowed to not manipulate or circumvent the normal currency market functions, it can become less trustworthy when it ends up doing so. That’s China’s problem—they tend not to be extremely transparent, anyway, so ‘surprise’ moves like this tend to catch global markets off-guard, although they aren’t really surprising from a long-term motivations standpoint. The Chinese government will do whatever it can to avoid economic weakness, which it fears would facilitate social class strife and even chaos (sounds extreme, but it’s happened before, leading to the creation of the communist regime in the first place), so it’ll do whatever means necessary to attempt to right itself. The 10% annual growth that the Chinese experienced for over 30 years from 1980-2010 or so has slowed to around 7% at this point. Not bad, but not the pace they’ve been accustomed to, so they are trying to evolve to a next level of thinking for the following phase of growth.

For perspective’s sake, U.S. exports to China represent only a few percent of GDP, which is often surprising. For American companies, a devalued Chinese currency (and implied inverse, a stronger dollar) means U.S. exported goods prices just became less competitive. A carryover to this is that, if the Fed ends up raising rates beyond expectations (not consensus at this point), the carry trade flow impact toward U.S. assets could serve to further strengthen the dollar, further hamper export activity, manufacturing, and exacerbate a negative spiral. The Fed doesn’t live in a bubble, and is no doubt cognizant of these intricate relationships. So, slow global growth and actions from big players like this has the potential to move a foot away from the higher-interest rate brake pedal just yet, despite domestic manufacturing and labor market improvements that could warrant it. So, a risk in postponing interest rate action until Dec. or beyond is there.

From an portfolio standpoint, investments in emerging markets, including China, should be viewed from a longer-term perspective. There will always be more bumps in the road here than in developed markets (although developed nations have had their own as well), with the objective being that long-term demographic trends and growth in industrialization could be long-term drivers of investment returns. In a world where growth is more difficult to come by, higher potential growth rates from such countries are an important engine in portfolios.

In the near term with equity values no longer dirt cheap (nor overly expensive), and the lack of any meaningful pareback in some time, we should expect that these types of news events may cause more fragility in markets and add to volatility. However, as was the case here after a day or two, cooler heads seemed to prevail when participants gave the repercussions more thought.

Source: Fidelity Investments

This is a complex conversation with few absolutes, and it can end up as a more complicated story for clients who are bombarded with ETF advertisements claiming rock-bottom fees and easy market access. These, of course, don't include spreads and other trading costs, as well as what a client might be gaining or losing by making the active or passive call. Only being armed with complete information can a constructive conversation be had and the most effective client decision made.

Additional Reading

Read our Weekly Review for August 24, 2015.

Read the previous Question of the Week for August 3, 2015.

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