If Shanghai’s stock market correction in July suggested that investors should be watching China not Greece, then the recent devaluation of the yuan confirmed it. What’s happening in Greece is largely irrelevant compared with the unfolding drama in Asia.
Trying to work out the implications of Beijing’s dramatic intervention in the currency markets is complicated by the fact that no-one is quite sure what really prompted it and, therefore, what is likely to happen next.
On the face of it there were two reasons for China to weaken the renminbi. The proximate cause appeared to be worse than expected export data confirming an even sharper slowdown in the economy than anyone believed. An abrupt economic slowdown looks increasingly like a good result for China. A soft peg to the dollar means that China has become progressively less competitive as the US currency has appreciated.
Beijing has tried everything else from interest rate cuts to lower reserve requirements and pumping up the stock market so it was perhaps inevitable that it would succumb to the temptation of a weaker currency. The daily fix of the exchange rate has been out of kilter with market reality for months now so lowering the reference point was no more than a nod to reality.
The second reason is the one that China would prefer us to believe. In the run-up to the International Monetary Fund’s decision later this year on the constituents of its de facto global reserve currency – the special drawing rights – China is keen to present the yuan as a market-driven unit worthy of a place alongside the US dollar, yen, euro and sterling.
China is keen on market forces when it suits and it is desperate to avoid the currency manipulator tag. It was, therefore, happy to pretend that cheaper exports were just an unintended consequence of its embrace of market reforms. The speed with which it has started intervening again this week to manage the pace of the yuan’s fall is an indication that it is better to watch what Beijing does than what it says.
Why should investors care about a slide in the renminbi against the dollar? After all it is merely catching up with what every other major currency except the pound has done over the past year or so. The reason, of course, is that every other country is not China. If Beijing is really determined to trigger a race to the bottom in order to keep its economy on the move then investors should not underestimate the knock-on impact.
The immediate stock market response was predictable. Western companies that are dependent on Chinese demand were hammered. Luxury goods makers like Burberry, car-makers like Peugeot and, most obviously, commodity producers were already struggling to cope with the economic slowdown. The last thing they need is Chinese consumers pulling in their horns even more because their yuan won’t stretch as far.
For investors in China, companies with domestic revenues but dollar-denominated costs are going to be hardest hit. The airlines like China Southern are obvious victims of a sliding renminbi, not just because of the rising cost of aircraft and fuel but because the sector has been a significant issuer of dollar-denominated debt. Chinese property companies have also been active in the dollar high-yield debt market on the basis that they would be protected by the yuan’s link to the greenback.
The impact of any competitive devaluations will be felt throughout the dollar-denominated debt markets in the region, meaning that bonds risk being the next shoe to drop after shares, commodities and currencies.
Arguably the biggest consequence of all, however, will emerge next month in Washington when the Federal Reserve has to decide whether to pull raise rates for the first time in the US since 2006. In theory, the US is under no obligation to consider the impact of its policies beyond its own shores. But the world is interconnected and it is hard to see how the US can avoid importing deflation via the depressing effect of an ever stronger dollar on US company profits.
The Fed may just have received the excuse it needs to put off the first rate hike until December. And it is becoming clearer that the peak in the next cycle is getting lower and lower. It’s been said before that the final bubble in this bull market would be triggered by a desperate search for growth and income in a stagnant world. That looks even more true today.
