Chinese Yuan DevelopmentsSubmitted by JMB Financial Managers on August 13th, 2015
On Tuesday, the People's Bank of China (PBC), the country’s central bank, announced a cut in its currency reference rate relative to the U.S. Dollar (USD) by 1.9%, down to 6.23 yuan/USD. This cut was followed by an announcement on Wednesday of another 1.6% decrease to 6.33 yuan/USD. The moves devalued the yuan and marked two of the largest single-day drops since China aligned its official and market currency rates in January 1994. Previously, the PBC had a mid-day target of 6.11 yuan to the USD, around which it allowed the yuan to trade in a 2% range.
The magnitude of both days’ moves was largely unexpected, although there had been some official discussions of widening the yuan’s daily trading range. The moves have had a widespread impact, as many emerging market countries, whose economies rely on raw material exports to China, also had their currencies decline. Oil and material prices are trending lower, and developed and emerging market equities sold off as investors are again becoming concerned about deflation risks. Safety assets, such as Treasuries and gold, are trading higher.
Why the Devalue in the Yuan?
There are several reasons that may explain the decision to devalue the yuan. Foremost among them is the slowdown in Chinese growth and continued decline in exports. As the U.S. Dollar has appreciated, the yuan’s near-peg to the greenback caused a 12% appreciation of the Chinese currency over the last year. This has made the country’s exports less competitive relative to nearby South Asian countries, which have lower wages and whose currencies are valued lower. Currency devaluation has the potential of recovering some of the lost competitiveness of Chinese manufacturers, and it may also provide some support to Chinese equities that have been under stress lately. Additionally, there is some recent evidence that the stronger yuan has increased capital outflows from China. A desire to slow capital flight in a slowing economy may be a second reason for the lowered yuan reference rate.
As China’s importance in exports and global trade has grown, the yuan has also seen increased use as an international payment method. With this development, Chinese authorities have expressed a desire for the yuan to be included in the basket of currencies used in valuing Special Drawing Rights (SDR) – the accounting unit used by the International Monetary Fund (IMF) in dealing with member countries. At present, a basket of four currencies is used to value SDRs: the Euro, Japanese yen, U.K. pound sterling, and U.S. Dollar. An IMF review of the SDR’s currency basket was expected in late 2015, but a review dated August 4 suggested that the yuan still does not meet IMF’s definition of a freely usable currency. As the yuan had been trading below the official reference rate in Hong Kong for some time, the PBC may be moving closer to market rates, in order to allow the currency to float more freely. This move, in turn, may clear the path for the yuan being considered a reserve currency, boosting China’s prestige on the world stage.
Our View of Things
From our perspective, China’s currency devaluation may have a pronounced impact on the markets. The effects on currencies and commodities may be lasting, while equities and fixed income may stabilize faster. In currencies, a contagion in Asian currencies that may trade lower as growth shifts back to China is likely. Commodities may trade lower as well, but if Chinese growth recovers, commodity demand may begin to improve. In equities, there are likely to be winners and losers as some manufacturing and export demand is likely to move back to China at the expense of nearby low cost producer countries, while exporters to China, such as Korean and Taiwanese chip manufacturers, may benefit. As domestic Chinese debt is not widely traded, we expect that the long-term impact on the fixed income markets may be limited. However, volatility may persist for some time and may cause Treasuries and other safety assets to trade higher.
This story is still developing, and at this point we have not made any portfolio changes in response to it. We continue to maintain an allocation to equities in line with long-term investment objectives, and with the prospect of higher interest rates in 2015, we recommend a defensive position in fixed income, with an overweight to credit sensitive bonds and a shorter duration.
To discuss how these changes may impact your personal portfolio schedule a free consultation with us today.
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About the Author
Jack Brkich III, is the president and founder of JMB Financial Managers. A Certified Financial Planner, Jack is a trusted advisor and resource for business owners, individuals, and families. His advice about wealth creation and preservation techniques have appeared in publications including The Los Angeles Times, NASDAQ, Investopedia, and The Wall Street Journal. To learn more visit https://www.jmbfinmgrs.com/.