China s Currency: No Longer a Yuan-Way Street

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1 China s Currency: No Longer a Yuan-Way Street China recently made a significant change to its exchange rate policy, raising many questions related to its intent. The move effectively devalued the Chinese yuan relative to the U.S. dollar. Those who would likely be affected are Asian economies neighboring China and economies that rely heavily on commodity exports. The U.S. would likely not be substantially affected given that exports and imports comprise a small portion of U.S. Gross Domestic Product (GDP). In mid-august, China suddenly made a major change to its exchange rate policy, shifting to a more flexible approach. This adjustment weakened the Chinese currency (yuan) against the U.S. dollar by nearly 2%. As investors had become used to a steadily appreciating yuan over the past decade, it took most by surprise, shaking global financial markets and raising many questions. The People s Bank of China (PBoC), China s central bank, characterized the change as a move into a more market-oriented exchange rate mechanism. Some market participants, however, saw the devaluation as an attempt to stimulate its sagging economy. While the true intentions of Chinese policymakers remain unclear, it is clear that the change in policy has important implications for the global economy and capital markets. In this paper, we attempt to provide some background on the various exchange rate, or currency, regimes and address the possible current implications of China s action. Exchange Rate Regimes The two basic currency systems are fixed and floating exchange rates. (There are also a number of hybrid systems that combine some aspects of each.) In a fixed exchange rate system, a country fixes the value of its currency with respect to one or more other currencies or to some asset or commodity, typically gold or silver. From 1995 to 2005, for example, China fixed the value of its currency to 8.3 yuan per dollar. Simply stated, an investor needed 8.3 yuan to buy one dollar. To maintain a fixed exchange rate, the monetary value of goods, services and assets that a country buys from the rest of the world must equal the amount it sells to the world. When this does not happen, there must be an adjustment to correct the imbalance. One adjustment is to cover the amount of the imbalance with an acceptable asset, known as an international reserve asset. 1 Under the gold standard, the amount of the account 1 A reserve asset is typically a currency that serves the role once played by gold, settling payment differences between nations.

2 imbalance would be settled using gold. Today, many countries use U.S. dollars to settle account imbalances. Any country that continues to buy more from the rest of the world than it sells to the rest of the world will eventually draw down its supply of international reserve assets. This typically leads to a currency devaluation the currency will decline in value relative to the currency or asset to which it s pegged (for example U.S. dollar or gold). With a floating exchange rate system, the exchange rate is determined continuously by supply and demand. If a country buys more goods, services and assets from the world than it sells to the world, there will be an excess supply of its currency and its currency will fall in value (depreciate) to restore equilibrium. If the world buys more from a country than the country buys from the world, its currency value will rise (appreciate). China s Exchange Rate Regime China has moved from a fixed exchange rate towards a more flexible approach over the past two decades. From 1995 through 2005, China pegged its exchange rate to the U.S. dollar at approximately 8.3 yuan per dollar. In mid-2005, China revalued the yuan by 2.1% against the dollar, while stating that it shifted to a managed float against a number of currencies. Since then, the yuan has appreciated rather steadily, rising about 33% against the dollar over the past ten years. During this period, it has been China s practice to set a daily currency fix (relative to the dollar), against which it allowed the yuan to trade in a band of +/- 1%. For example, if China sets the daily fix at 6.5 yuan per the dollar, the yuan trades in a range of to per dollar. If the currency were to get close to either side of the band, the PBoC would intervene to keep the yuan within the daily approved range. The daily fix remained relatively stable over this time, deviating ever so slightly from the previous day s fix. China s established practice changed abruptly on August 11 th of this year. China began to set the daily fix according to the previous day s market closing price, rather than setting it in line with the previous day s fix. As the yuan ended August 10th trading close to the identified downside of its band, this change had the effect of devaluing the yuan against the dollar by the largest amount since China ended its currency peg in 2005 (See Figure 1). It also widened the currency s trading band to +/-2% from +/-1%.

3 Figure One Percentage, % Daily % Change in U.S.Dollar/Chinese Yuan 2.5 Exchange Rate 2.0 CNY 1.5 depreciation CNY -1.5 appreciation Aug-03 Aug-06 Aug-09 Aug-12 Aug-15 Possible Motives Source: Thomson Reuters Datastream. China s move followed a number of poor economic reports, including a decline in exports of 8.3% from a year earlier. Some economists interpreted this change in approach as an attempt to stimulate economic growth by lowering the cost of its exported products. Recent currency strength may have played a role in China s slowing economy, particularly over the past year or so. During this period, the yuan has appreciated (rapidly, in some cases) against the currency of many of its primary trading partners (see Figure 2). This is largely due to strength in the U.S. dollar (as China has loosely pegged the value of its currency to the U.S. dollar). As the dollar strengthened, it pulled the Chinese yuan up in value with it. While the yuan has depreciated against the dollar over the past year, it is still up about 27% against the Aussie dollar, 12% against the Japanese Yen, 9% against the Singapore dollar, and 8% against the Taiwanese baht. This means goods from China have become more expensive relative to those from many of their trading partners. This has the effect of decreasing the demand for Chinese exports.

4 Figure Two 130 Chinese Yuan Cumlative One-Year Growth Aug-14 Nov-14 Feb-15 May-15 Aug-15 U.S. dollar Aussie dollar Japanese Yen Singapore dollar Tawinese Bhat Source: Thomson Reuters Datastream. Others believe this move is to support China s goal of becoming a bigger player in the global financial realm. Specifically, China would like the yuan to be included in the International Monetary Fund s (IMF) basket of currencies used to compute the value of its Special Drawing Rights (SDR), the IMF s basic unit of account. The recent change would seem to move China further in this direction, setting the stage for the yuan to become a global reserve currency. The truth likely lies somewhere in between, particularly given that both of these explanations are applicable at this time. First, the devaluation is a tool to ease financial conditions given a renewed downturn in China s economic activity. Second, China s move to make the exchange rate more market-oriented is consistent with the IMF s desire for China to make greater progress toward exchange rate flexibility. Economic and Market Implications The devaluation itself has economic and financial market implications. From an economic perspective, the depreciation is likely to have little impact on Chinese GDP growth. While some market participants saw it as a ploy to grow exports by gaining competitiveness, the Chinese economy is not nearly as export-driven as it once was. According to Ned Davis Research, net exports have either added or subtracted no more than 0.1 percentage points to annual real GDP growth during the last six calendar years.

5 Still, many market participants interpreted the move as signaling that the Chinese economy is in worse shape than the economic data alone would imply. While the official economic growth target for China this year is about 7%, many economists believe growth may be below that level. 2 From a global perspective, Barclays estimates that a 200 basis point (bp) deceleration in the rate of Chinese economic growth would reduce the rate of global economic growth by about bps, though certain economies would see a material impact, while others would remain relatively unscathed. Those who would likely be affected are Asian economies neighboring China and economies that rely heavily on commodity exports (Australia, Brazil, Canada, etc.). Some are closely intertwined with China given their proximity, others may see a reduction in demand for their chief exports (iron ore, steel, oil, etc.). The U.S. would likely not be substantially affected given that exports and imports comprise a small portion of U.S. GDP. Therefore the U.S. economy is not greatly influenced by the change in Chinese economic growth. The capital markets implications, however, are not as clear. A greater-than-expected slowdown in the Chinese economy may keep downward pressure on commodity prices (see Figure 3), emerging markets currencies and emerging markets equities. Figure Three Yearo-over-Year Percent, % China Industrial Production vs. Commodity Prices Jul-05 Jul-07 Jul-09 Jul-11 Jul-13 Jul-15 Yearo-over-Year Percent, % Industrial Production (LHS) DJ-UBS Commodity Price Index (RHS) Source: Thomson Reuters Datastream. Given the absolute and relative performance of emerging market currencies and emerging market equities over the past few months (and few years), the headwinds of a slowing Chinese economy and lower commodity prices seem to be already somewhat discounted into their prices. Emerging market equities, for instance, lost about 25% of their 2 Economists have long questioned the accuracy of Chinese economic data. The current general consensus is that economic growth is being overstated.

6 value from their 2015 peak. This performance has left the MSCI EM Index with a total return of negative 3.3% over the past four years, compared to a total return of 15.2% and 6.3% for U.S. and international developed markets, respectively. Predicting the possible impact on fixed income is a bit trickier. All else equal, a slowdown in the global economy, coupled with the idea that the Federal Reserve may not raise interest rates this year amid the increasingly uncertain economic growth environment, would likely put downward pressure on global sovereign bond yields. Yields for most government bonds, however, actually rose during the month, while the yield on the 10-year U.S. Treasury bond was unchanged. Some investors have speculated the lack of any gain in U.S. Treasury prices was a result of China having to defend its currency in the wake of its devaluation. After China devalued the yuan, investors sold yuan in anticipation of further weakness. This caused China to sell dollars (Treasuries) and buy the yuan in order maintain currency stability. As this likely occurred during the equity market weakness, Treasury prices did not rise to the extent that would be typical during a sharp 10% decline in equities. Conclusion China s recent move to devalue the yuan was unexpected. While it is unlikely to have a big economic impact, the change in policy introduced the perception that Chinese economic growth might be weaker (perhaps much so) than Chinese policymakers are disclosing. This increased uncertainty was one of the main catalysts for the recent equity market selloff. While U.S. equities did not escape the market turmoil, it s important to maintain perspective. Markets have been on a tear for the past six years, experiencing hardly any bumps along the way. August was a reminder that markets are cyclical, reinforcing the importance of a sound investment plan. This should include a rebalancing policy and asset allocation that is in line with both the long-term return requirements of the Fund and its risk tolerances. It s best to perform a review of these items on a pre-set schedule. Doing a spur-of-the-moment review when the market moves materially may alter short-term perceptions of what is and is not appropriate, possibly leading to-less-than ideal investment decision making.