China’s stealthy currency devaluation

We’ve all been hearing plenty about the depreciating Pound Sterling post-Brexit. We’ve been hearing about the depreciating Euro and the Japanese Yen. We’ve even been hearing about the depreciating Swedish Krona. But perhaps the most important devaluation of all is the one about which we have been hearing very little.

Rewind the clock by 15 months and China’s sudden and surprising three percent devaluation in a day was all anyone could talk about. The suddenness of this devaluation signalled to global financial markets that perhaps the Chinese economy was weaker than first thought; and that the People’s Bank of China could no longer stem capital outflows by selling foreign reserves to buy back domestic currency that sought to leave the country. Global equity markets sold off by more than 10 percent in less than a month.

For more information about last year’s devaluation, see here and here.

As we argued in these prior notes to clients, one of the reasons China’s currency devaluation was of concern was because: “it was the clearest admission yet that Chinese policymakers are unwilling to take the necessary steps to rebalance the nation’s economy away from being investment-led, to being consumption-led.”

Well, as illustrated below, that three percent devaluation has now turned into a nine percent devaluation! Rebalancing would appear well and truly off the table for now. Instead, China has resorted back to fixed-asset investment and to supporting its low-value-add manufacturing sectors.

1 USD = (CNY):

* Note: upwards sloping implies CNY devaluation against the USD

Source: Bloomberg

Now a cheaper currency makes one’s exports relatively more competitive versus one’s neighbours. So as China devalued its currency over the last 15 months, countries like Europe and Japan were not particularly impressed.

Interestingly, what has happened in recent months is that China’s currency has broadly stabilized versus these currencies. This is illustrated below. Yet, as these currencies depreciate against the US dollar, so too will China’s currency. And that is exactly what has been happening.

Chinese Yuan Comparisons:

Source: Bloomberg

We would expect this trend to continue – particularly if the Federal Reserve raises interest rates. And while a cheaper currency is giving China’s heavily-indebted manufacturers some temporary breathing space, it is also raising financial risks. Remember, there is roughly US$10 trillion in USD-denominated non-bank credit out there (see here) which only becomes more expensive and difficult to repay as the US dollar appreciates relative to global currencies.

This is something to keep an eye on as we round out 2016 and move into the new year.

Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.