The devaluation of Chinese Yuan: A both unexpected and inevitable movement

The devaluation of Chinese Yuan: A both unexpected and inevitable movement

China has devaluated its currency twice in the past two days, which has surprised markets given that the yuan has been pegged to the US dollar for a long time. While currency traders are busy covering their positions, let’s have a closer look at what is happening.

Chart 01. The number of Chinese yuan that one US dollar can buy jumps suddenly as the Chinese government devalues the currency

Source: Rivkin, Saxo Bank

The background – a reaction to the economic reality

The end of the easing cycle last October and an expected rate hike by the US Federal Reserve this year has propelled the US dollar to appreciate throughout the past 12 months. As the currency increases in value, yields on US assets also appreciate, which helps drive capital flowing out of developing countries and back into the US. 

Such capital outflow from emerging economies has therefore put pressure on the value of all other currencies besides the US dollar, as investors start exchanging “foreign” assets for the US dollar denominated ones. As one of the developing country currencies, the Chinese yuan has been facing the headwind of devaluation. Furthermore, China’s “New Silk Road” plan will require capital to fund new projects. This will also drive a natural sell-off of Chinese yuan to some extent; however, its peg to the US dollar has stopped the yuan from naturally depreciating. 

The continuing appreciation of the US dollar has forced the yuan to appreciate against all of its other counter-party currencies. Even after the natural devaluation that has taken place, the Chinese yuan is still up by more than 10% compared with its value 12 months ago, due to the managed US dollar peg policy adopted in China, which has blessed Chinese economy and smoothed its financial account for decades.

But this policy is now hurting the economic fundamentals of China’s export economy: the attractively low price of export goods is being threatened. China’s July Producer Price Index (PPI) read has witnessed its largest decline since October 2009. This figure, accompanied with the disappointing Caixin Final Manufacturing PMI numbers released last week, reinforced the view of a slowing down of the Chinese export economy. It has been increasingly difficult to retain confidence in the 7% annual GDP growth target – an expectation set by the Chinese government – without significant government intervention with monetary and fiscal policy. Therefore, the devaluation decision is very likely a reaction to the economic reality faced by China: it must support the export economy by devaluing the local currency. The “world’s factory” still wants the rest of the world to buy its stuff at a cheap price.

Reactions to “the reaction”

Vietnam has just widened the trading band of its own currency by one percent on Wednesday 12 August. Japan and Korea have devalued their currencies by 40% and 15% respectively over the past two years. A cheaper yuan will definitely have a negative impact on some Asian countries that are mostly export-oriented. The recent movement of Chinese yuan may have just crossed the flash point of reigniting a new round of currency warfare in the Asian-Pacific regime.

The Australian dollar has been closely following the movement of the yuan – as has the New Zealand dollar. These yuan-sensitive currencies will likely experience short-term fluctuations, with a downward trend being the most likely outcome. If investors are no longer convinced of the “Chinese Dream” that is driving the world’s second-largest economy, disinvestments in China will push the yuan lower, which again fuels dumping of more yuan-denominated assets. As the Chinese government has intervened heavily to prevent its stock markets from crashing, it will certainly do even more to prevent its currency from heading south too quickly. A cheaper yuan also means China has to pay more to import resources like iron ore and oil. Therefore, a stabilised currency trading in chorus with the US dollar is optimal and the downside of the yuan – in my opinion – will be limited.

The International Monetary Fund has welcomed the devaluation, citing in its August 11 Press Line that the movement is “a step forward towards allowing the market forces to have a greater role in setting the exchange rate” and “regarding the ongoing review of the IMF’s SDR basket, the announced change has no direct implications for the criteria used in determining the composition of the basket.” Furthermore, the devaluation may also put a lid on a possible rate hike decided by US Federal Reserve, who will surely review the risk and reward scenario. Let’s keep in mind that the devaluation decision was made just weeks before the most anticipated September US Federal Reserve meeting. Indeed – for local investors – a slowdown in US rate hike expectations may provide some relief to the Australian equity market.

In conclusion

My opinion is that is unlikely that we are seeing the start of a devaluation trend in the yuan. The world’s second-largest economy is still performing. A transparent and stable, if not predictable, monetary policy for the Chinese yuan is in the interest of both China and the rest of the world. After all, the People's Bank of China is not the Bank of Japan – it is not setting out upon a strategic manipulation of its currency. The devaluation should be read as a reaction to the stronger US dollar status.

Ultimately, to avoid surprising the market again, it is almost inevitable that the Chinese yuan needs to be free-floated. As for currency traders, volatility is a friend as well as an enemy. In the short term, the yuan-sensitive currencies will follow the downward movement. It is hard to predict the bottom at the current stage; however, the market will find buyers eventually and a new normal will be formed for yuan trading.

Complex product warning

This article contains information about foreign exchange contracts, which are considered complex financial products. Please click here to read ASIC's foreign exchange trading article before considering an investment in foreign exchange contracts. 
comments powered by Disqus

DISCLAIMER: Rivkin aims to provide clear and simple information to those visiting our website. If any part of this disclaimer does not make sense, please phone Rivkin and ask to speak with a member of our Dealing and Relationship Management Team. Rivkin provides general advice and dealing services on securities, derivatives and superannuation (SMSF). Rivkin also provide SMSF administration and accounting services. Rivkin does not provide advice that takes into account your, or anybody else's, investment objectives, financial situation or needs. We strongly suggest that you consult an independent, licenced financial advisor before acting upon any information contained on this website. Investing in and trading securities (such as shares listed on the ASX) and/or derivatives (such as Contracts for Difference or 'CFDs') carry financial risks. CFDs carry with them various additional risks that differ from more simple securities such as fully-paid company shares. Some of these risks include not owning the underlying instrument from which a price is being derived, settling trades 'over the counter' with a financial institution rather than on a stock exchange, and using leverage to gain access to trades that may have a higher face value than your initial deposit. This risk of leverage means that it is possible to lose more than your initial investment. Our aim is to create more life choices for our clients, which means improving the wealth of clients throughout many market cycles by nurturing a relationship spanning many years. If you are not comfortable with your understanding of the risks involved before using a Rivkin product and service, please contact our office to seek further information or a Product Disclosure Statement, or make an appointment to sit with one of our friendly financial experts. It is in our interest for your Rivkin experience to be a rewarding and comfortable one. Rivkin is a trading name of Rivkin Securities ABN 87123290602, which holds Australian Financial Services Licence No. 332 802.