China prompted shockwaves in global markets in August 2015 by allowing its currency, the Yuan, to weaken outside of its previous trading band based on market movements.
In its policy move, the Chinese government said it would consider the previous day's trading in its establishment of the currency rate, effectively considering the influence of the market. With the announcement, the currency immediately fell about 2%, to the floor of the official trading band.
In its statement, China's government said that "henceforth the mid-point of an expanded 2% band within which the currency can move on any single day would be based on the previous day's closing value." It also said the currency rate would be determined by "demand and supply conditions in foreign exchange markets and the movement of major currencies."((Retrieved [27 September 2015] http://www.safehaven.com/article/38661/china-weakens-the-yuan-rattles-global-markets))
Chinese Currency Policy
Contrary to many of its trade partners internationally, which allow the values of their currencies to float more or less freely against others, China has a managed currency policy. It regulates trading activity and tries to control daily movements of the yuan through intervention in the forex market.
The Chinese government had traditionally pegged the yuan directly to the dollar, but in July 2005 made a move toward a liberalisation of its currency policy by introducing a narrow trading band. Over the past 10 years, the government has gradually allowed the trading band to widen, at first from +/- 0.3%, to +/-1% in 2012, and finally to +/-2% by March 2014.((Retrieved [27 September 2015] http://www.mercer.com/content/dam/mercer/attachments/global/investments/whats-behind-the-chinese-currency-devaluation-letter.pdf))
At the encouragement of trade partners around the globe, the Chinese government had been following what it called a "strong yuan" policy. Because the yuan has been pegged to the US dollar, it has followed the dollar's rise over recent years. The latest announcement, however, added a market reference to the policy, effectively allowing for the controlled weakening of a currency that the market had considered to be overvalued.
The motive of the timing for the policy move to weaken the currency is not entirely certain, but Chinese officials gave some hints about their rationale.
Yao Yudong, head of the Institute of Finance and Banking at China's central bank, told the Reuters news service that the move was prompted by concerns over a possible US interest rate rise that may have fueled capital flight out of emerging markets.
"China's exchange rate reform had nothing to do with the global stock market volatility, it was mainly due to the upcoming US Federal Reserve monetary policy move," Mr. Yao said. "We were wronged."((Retrieved [27 September 2015] http://profit.ndtv.com/news/forex/article-dont-blame-yuan-devaluation-for-global-market-rout-china-central-bank-official-1211746))
A possible Federal Reserve interest rate hike and rising U.S. returns, long hinted at by the Fed, would have the effect of attracting global investment funding away from emerging markets and toward the U.S. Investors have traditionally considered that the U.S. provides a safer harbor for investment than many of its counterparts abroad.
The Chinese Economy: Cushioning for a soft landing?
Meanwhile, some analysts took the Chinese currency move as a sign that the country would focus less on the export market and more on its internal consumption going forward.((Retrieved [27 September 2015] http://www.businessspectator.com.au/article/2015/8/11/china/why-china-changed-its-exchange-rate-policy))
After posting double-digit growth rates over the past decades, China's economy grew only 7.4% in 2014, its lowest level in 24 years. The rate, while relatively high in comparison to other countries, is seen by economists as low for sustaining prosperous conditions in China, which must guarantee opportunities and sustenance for the country's population of 1.4 billion people.((Retrieved [27 September 2015] http://www.usatoday.com/story/money/business/2015/01/19/china-2014-growth/22028737/))
In the wake of the 2008-9 global financial crisis, China instructed its banks to stoke the economy with loans for investment in infrastructure for housing, transportation and manufacturing. Part of the effort involved selling shares of companies to pay off debt. But growth of industrial production in China has declined from near 20% before 2010 to around 6% in 2015. Moreover, China's exports fell more than 8% in July 2015. As part of an investor reaction to these trends, China's stock market lost nearly 30% of its value.((Retrieved [27 September 2015] http://www.schwab.com/public/schwab/nn/articles/Currency-Wars-Is-a-Weaker-Currency-Good-or-Bad))
Undervalued or Overvalued?
While China's currency has in recent years been criticised by the country's trade partners for being undervalued, the currency's latest moves in the market support a recently revised view that the yuan has actually become overvalued. Indeed, it has strengthened against the dollar by more than 30% over the past two decades.
The view that the currency had become too strong was apparent by the second quarter of 2015 amid signs that China's activity, trade and growth were waning after years of outperformance.
In parallel to the currency's shifting value, China's government has signalled its long-term intention for the yuan to become an international reserve currency. Part of that effort involved the yuan's inclusion in a basket of currencies making up the International Monetary Fund's "Special Drawing Rights."
The IMF's Special Drawing Rights, or SDRs, are a virtual currency that can be lent to central banks to cover the balance of payments shortfalls. The inclusion of the yuan currency in the SDR basket, however, is dependent on an IMF review of China's capital account in addition to reforms to China's investment policies to boost investor confidence in the transparency of its markets over the long term. ((Retrieved [27 September 2015] https://www.imf.org/external/np/sec/pr/2015/pr15237.htm))
What Will This Mean for China?
Typically when managed currencies are allowed to weaken significantly, governments are aiming to improve their trade and current account balances by discouraging imports and boosting exports. However, studies by the World Bank have shown that the correlation between trade and currency depreciation has weakened in recent years.
This is possibly due to more complex manufacturing supply chains, where goods are manufactured with components from many different countries. This factor seems to reduce the immediate trade advantage of a weaker currency on given products. Many countries, such as Japan, South Korea and Taiwan, have seen sharp currency weakening over the past year, but they haven't necessarily posted corresponding improvements in their trade balances.((Retrieved [27 September 2015] http://www.cnbc.com/2015/08/19/currency-wars-unlikely-to-be-successful-despite-yuan-move.html))
Part of the difficulty may have been related to China's currency control system itself. Because the currency was tightly pegged to the dollar, its movement remained restricted while other, competing currencies were allowed to weaken. At the same time, a weak economy and balance of payments deficit has forced China to spend some US$300 billion in foreign currency reserves over the past year.((Retrieved [27 September 2015] http://www.businessinsider.com.au/everything-you-need-to-know-about-why-china-is-weakening-its-currency-2015-8))
Currency outflows from the Chinese economy, meanwhile, could force credit tightening in the country and reduce the availability of credit for continued expansion there.((Retrieved [27 September 2015] http://thismatter.com/money/banking/foreign-exchange-interventions.htm))
The Impact on Trade and the Global Economy
The move to weaken the yuan continues to draw criticisms from U.S. industries and politicians, who suggest that the change will cause an unfair trade advantage for Chinese goods in the States and other countries.
As a result, the move could cause difficulties for trade deals. The U.S. and Asian trade partners are negotiating the Trans-Pacific Partnership Agreement, known as the TPP, which is a broad free trade deal. China is not currently a participant in the negotiations, but it could be under consideration for future inclusion. However, under negotiation rules passed by the US Congress, the U.S. has said it will show "zero tolerance" for currency manipulation, meaning any suspected deliberate efforts to weaken the Yuan could raise yellow flags.((Retrieved [27 September 2015] http://fortune.com/2015/08/19/what-chinas-currency-devaluation-means-for-the-worlds-trade-deals))
The weaker yuan will also mean less Chinese money going to purchase exports from key commodities producing countries like Australia and Brazil, helping further depress already lower commodities prices. This will mean falling prices for oil, metals and grains in addition to diminishing pressure on inflation. On the tail of the Chinese action, many emerging market currencies like Turkey's lira, Indonesia's rupiah, South Africa's rand, Vietnam's dong, Brazil's real and Mexico's peso also weakened in value.((Retrieved [27 September 2015] http://www.weeklystandard.com/articles/china-s-currency_1032581.html?page=2))
With concerns about the weakening of the Chinese economy and its repercussions, global stock markets registered steep selloffs in late August and early September 2015.
China's weakened currency is sure to have an ongoing impact on global markets going forward. In particular, it will make exports to China more difficult, as goods denominated in dollars and other currencies will be more expensive for Chinese consumers. This impact could further show up in the earnings of multi-nationals that export goods to the large Asian economy. Likewise, manufactured goods from China, such as tablet computers and smartphones, should become less expensive abroad.
This factor could show up as a knock-on effect for economies such as the U.S., bringing costs and inflation lower. If this occurs, the immediate implication for the US economy may be to encourage the Federal Reserve to hold off further on its plans for an interest rate hike. The bank had been signalling a possible increase in interest rates as early as October 2015 to curb mounting price pressure, after holding rates at near zero since late 2008.((Retrieved [27 September 2015] http://www.ibtimes.com/4-ways-chinas-devalued-yuan-could-hurt-us-economy-2049204))
Impact on the Currency Market and Trading
China has traditionally used its substantial foreign currency reserves, which currently total some US$3.5 trillion, to help stabilise the currency through foreign exchange market interventions. To weaken the currency, the Chinese central bank sells foreign currency reserves, normally dollars, into the market. Conversely, if the country wants to strengthen its currency, it uses its local currency to buy foreign currency.
The country had been spending about US$50 billion per month to defend the level of its currency, but it spent more than US$120 billion in August 2015 under the impact of the currency weakening. Traders betting on a steep decline in the currency will have to contend with the fact that the Chinese central bank has ample firepower in its currency reserves to maintain the yuan within a stable range.
The greater flexibility of China's currency policy, however, is seen possibly attracting larger interest of currency speculators into the market for the yuan.((Retrieved [27 September 2015] http://www.safehaven.com/article/38661/china-weakens-the-yuan-rattles-global-markets))
More Weakening Ahead?
With a slowing economy and lower investment inflows to China, the pace of currency intervention (at US$50-100 billion per day) could become unsustainable, even with large currency reserves.
Given this reality, some analysts and traders are betting the Chinese Central Bank will continue working toward a further devaluation of the yuan over the coming periods to make China's exports more competitive in the world market. If the country's economy weakens substantially, however, it may see itself forced to cut its local interest rates and allow the currency to fall more steeply.((Retrieved [27 September 2015] http://www.dailyfx.com/forex/fundamental/article/special_report/2015/08/11/What-Does-Yuans-Devaluation-Mean-for-Chinese-and-Global-Markets.html))
In addition to presenting new opportunities for trade with the yuan, China's policy move should encourage more trading with other emerging market currencies that have been influenced by the action. That may hold true particularly in Asia, where China's economic output accounts for more than 40% of the region's total.((Retrieved [27 September 2015] https://www.alphaipartners.com/FileDownload.aspx?Id=2592))
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…