Chinese authorities have decided early this week to let their currency depreciate by changing the way they control the exchange rate mechanism. They want to introduce more flexibility and more market orientation to the fixing of the exchange rate. The objective of this change of policy is mainly to support the economic growth of China.

Macroeconomic context

The depreciation movement launched by the Chinese authorities is driven by international macro politics and plain economy.

China wants to get the Yuan into the International Monetary Fund's reserve assets known as special drawing rights (SDR). The current SDR currencies are the USD, the GBP, the JPY and the EUR.

To be included in this close circle, the IMF takes several criteria into account and most importantly:

  • the level of international economic exchange (and for this China is already a more global player than the UK or Japan);
  • The currency must be widely available (“freely usable”), i.e. the currency needs to be used to a great extent as a regular form of payment in international commercial exchanges.

For this second point, the IMF thinks that the Chinese currency will meet its criteria by November 2016. So to gain time the Chinese authorities had to act now.

On the economy side, it is widely known that the Chinese economy is slowing down. A depreciation of one’s currency is an easy move to boost one’s exportations.

To help its flagging economy, the Chinese government has already taken several steps. They will boost infrastructure, lower rates, increasing loans to banks…. Devaluate the currency will give further breathing space to their exporting companies, as exports are falling by 8% (vs an increase of 20/30% in the first decade of this century).

Since 2005, the Chinese currency has appreciated by more than 60% against its main trading partners (+30% vs. the USD since 2006).

Regionally, all its neighbours (Japan, Korea, Thailand, Malaysia….) have seen their currency depreciate in the last years (-30% for the JPY).

A currency FX reform was then needed for China. A more flexible exchange rate mechanism would allow the CNY to play a bigger role in helping its economy and boost its international role. With the recent adjustment, the Chinese currency is now closer to its fair market value.

In the long term, the PBoC believes its currency should continue to be a strong currency, given China's current accounts surplus, large FX reserves and stable fiscal and financial conditions. The central bank also repeated its intention to keep the currency basically stable at an equilibrium level, although it hasn’t explicitly said how….

Is there a limit to the currency downfall?

China has the means to manage its currency devaluation and we think that the Chinese authorities will not let their currency depreciate untidily. If the fall would go beyond 10% we could see capital outflows occurring and this would also threatens talks with the IMF over the SDR membership.

This would also give a halt to the rebalancing of the economy from an exporting economy-based model to a more domestically oriented consumption model. In the meantime they need to boost their exports. The current depreciation will increase the inflation, mainly through “imported” inflation.

Negative reactions from their trading partners (US in particular) could also occur with a continuous fall of the currency.

What are the consequences of such a depreciation?

Markets reactions will depend on how much the PBoC will let the currency depreciate. If the fall can be sustained at 5-10% we will not see a currency war in the region.

But further depreciation could delay anticipations of the Fed’s first rate hike later in the year. This could also trigger a new round of QE in Japan.

For European companies this is not good news since they will benefit less from the competitive advantage given by the depreciation of the EUR. Commodities; Emerging Markets currencies and credit terms in the Emerging Markets could also further deteriorate.

Most important, this depreciation move could further impact global markets if it reveals a very low level of growth in China, lower than officially reported.
On the contrary, if the current fall does not impact the global growth profile this could be paradoxically positive for risky assets with more dovish messages from Central Banks (and in the end even create a buying opportunity for Chinese markets).

Even with a stabilisation at around 5% in the coming days, we could see further depreciation later on. But as long as it remains around the 5-10% level, it should not be adversely interpreted by markets.

What is our asset allocation in this context?

Thus, the degree of depreciation will be a key element and if this devaluation revealed a very low level of growth in China, it would also be more negative than what investors expect. We will monitor closely the way the Chinese government manage this currency depreciation and we remain confident with our current positioning:

  • We have no overexposure to emerging markets equities and in our overweight in emerging debt, we prefer hard currency debt than those in local currency.
  • In the high yield environment we are focused on a strong selectivity.
  • Our overexposure on European equities and especially our tactical overweight on the Ibex and the MIB was also beneficial as these two indices suffered less than the global euro zone equities index.

 

The Macro Team

Actualités macro

Lire nos articles