Chinese Checkers: Devaluing Yuan

Published on 13 Aug, 2015

China Market Research

An Exercise in Laissez-Faire

In a bid to support their stuttering economy, China has devalued its currency, leaving it 5% weaker than the US Dollar over the last three days. Being the world’s largest trading and export economy, this move has rattled the financial markets across the globe. With severe ramifications and a fear that other export oriented economies will follow suit in order to remain competitive, this may open a Pandora’s box of depreciation.

The Trigger and Consequence of Devaluation

The devaluation signifies a major shift in the pricing regime by China, from a tightly controlled peg against the Dollar to a more liberalized exchange rate determined by market forces. While the PBoC communicated that the move is a “one time correction” a bigger question is “will China set a trend to propel the economy which is reeling under pressure?”

This drastic measure comes on the back of lower trade numbers, with exports falling by 8.3% y-o-y (in Dollar terms) in the month of July against the consensus estimates of 1.5% (Bloomberg). This extreme action comes after a series of rate cuts since January meant to boost the sluggish economy, and it raises a key question over the state of the economic affairs in China that have left the global markets jittery.

Given concerns about economic growth, the equity sell-off, and sustainability of the government’s intervention in the broad financial markets, we believe sentiment on RMB is already negative.

Rate Cuts and reasons for Devaluation

While an initial devaluation of 2% could be termed as insignificant, a larger move of say 5-10% could be the beginning of a global market tailspin. We fear, given fragile economic scenarios, that the risks to the downside are higher; especially now that the PBoC has signaled a shift in the weaker direction, and this would set in motion a trend of weakness in other emerging economies.

China’s unexpected devaluation move could potentially pressurize central banks in other parts of world to depreciate their currencies in order to maintain export competitiveness and stabilize capital flows. RMB depreciation would also trigger a new bout of commodity weakness, which in our view, is not helpful. It could create deflationary pressures and push out any benefits from higher interest rates.

Risk of currency war

How Does The Devaluation Help or Impact Corporates?

Any company reporting its financials in USD with Asian operations or exposure would witness an earnings pressure due to the devaluation of Asian currencies against the USD. Thus the RMB devaluation, which has triggered the depreciation of other Asian currencies, would act as a headwind for revenue and margins.

There would however, be beneficiaries as well. Let’s look at a few winners and losers as a result of the fallout of the Chinese decision to let its currency depreciate. The biggest gainers are inarguably the exporters, supply chain managers such as Li & Fung, and I-phone assembler Foxconn to name a few. The higher wage cost in Southern China, which forced most of their factories to relocate their low-end production activities to other Southeast Asian countries such as Vietnam, could use this windfall of cheaper currency to cash in on the move. Global consumers would also emerge winners as the cheaper Chinese goods would make further inroads in the shopping markets across the US and elsewhere.

Among the losers, the Chinese airline industry would be deeply impacted as a cheaper currency would make foreign travel expensive. Coupled with high fuel costs, this depreciation will severely dent their profitability, as payments for oil is denominated in US Dollars. A weaker RMB would hurt the sales of American companies that look at Chinese consumers as a major market for their products as well. For banks, apart from the translation effects, forex volatility could also affect asset quality.

winners and losers currency war

En Route Towards IMF SDR Basket Inclusion?

China’s move to shift its currency quotation method from a fixed peg against the dollar to a market determined exchange rate could be viewed as part of China’s step towards IMF Special Drawing Rights (SDR) basket inclusion, which tends to confer on its members a status as a reserve currency. While there could be several other key operational concerns that the IMF would have, one of the reasons for this shift in the USD/CNY fixing policy can be attributed to the IMF document highlighting that a more “market - based representative RMB rate in terms of the US Dollar would be needed to value the RMB against the SDR” — which is an operational consideration hindering RMB’s inclusion in the SDR basket.

Currency Devaluation — Beneficial or Detrimental?

While there are ramifications across asset classes owing to the devaluation of the Yuan, the severity of it can be gauged only once it’s clear whether the depreciation is a one-off event or an on-going phenomenon designed to help exporters, in turn providing impetus to the economy. From a political perspective, this could add fuel to the ongoing criticism that China keeps the currency artificially lower to support its own manufacturers while harming companies in other countries that trade with China. A concurrent impact could also be on the additional capital outflows from China if the fear of further devaluation is not allayed. How China manages fixing the daily exchange rate and FX market flows in the coming days will be very interesting to watch out for.