It’s been a bit more than a week since China, the perceived bedrock of stability, shocked the markets and just let its currency fall by 3 percent in two days. Here is what happened, why it happened, and what the future holds.
China’s currency, the renminbi dropped roughly 3 percent against the dollar over the course of two days starting Aug. 11. Three percent isn’t really much, especially since other currencies such as the euro and the yen move by more, sometimes in a single day.
The main difference with China is that the currency is not freely traded. The People’s Bank of China (PBOC) officially sets a rate and allows trading to fluctuate 2 percent around that rate. Like this, the renminbi (yuan) was pegged to the dollar for 10 years and the PBOC let the yuan rise 21 percent over the period.
Many lawmakers in the United States always thought the yuan should rise much higher, given China’s fast economic growth and burgeoning exports to the United States. So they were dumbfounded when first the International Monetary Fund (IMF) said the yuan was fairly valued in the spring and then the market said it was overvalued when the PBOC let loose of its reins in August.
Of course, the PBOC did not completely let go. It merely said it would take the previous day’s closing rate as the official rate for the next day and keep the 2 percent band. In practice, this means the bank will still intervene when it pleases and also the yuan won’t be able to move more than 2 percent per day.
Why Did They Do It?
Except for a few astute observers like Diana Choyleva from Lombard Street Research, most of Wall Street was caught off guard. For a long time Choyleva said that the yuan was overvalued, especially considering domestic deflation.
“As we have argued, growth has weakened sharply under the burden of the overvalued yuan and capacity excesses while monetary conditions are tight,” she wrote in a note. Lombard’s Charles Dumas estimated in May that the exchange rate was 15–20 percent overvalued compared to 2010 when exports where growing strongly.
Exports have recently cratered (down 8.3 percent over the year in July), which is why most commentators have attributed the shift in policy to an old-school devaluation aiming to promote exports. This very shortsighted economic policy aims to cheapen domestic goods on international markets simply by cheapening, that is, devaluing the currency.
This argument is not without merit and Chinese authorities would certainly appreciate some extra growth through added exports. However, net trade only added 2.56 percent to GDP in 2013 and has declined further since.
Instead, domestic investment in real estate and infrastructure made up the shortfall in growth until the real estate bubble popped in 2014. Even Lombard notes the odd timing of the move.
Jeffrey Snider of Alhambra Investment Partners thinks Chinese banks and corporates are actually running out of dollars and the PBOC had to act quickly to prevent a market panic.
“Chinese banks, which previously had surplus dollars had to go tap international markets to get dollars for corporations as Chinese exports started to slow down in 2012 to finance trade,” he said. This would explain the yuan constantly trading at the lower end of the band set by the PBOC for the past year.
It would also explain the incessant selling of foreign exchange reserves by the PBOC to support Chinese private sector dollar demand: The reserves are down by $317 billion since August 2014, according to Bloomberg. Snider believes even China’s massive $4 trillion pile might not last forever:
“The outflows have been tremendous. There is no guarantee that this will remain stable, and if conditions worsen, it could grow exponentially into a run,” he said.
Of course, it’s not just Chinese corporations which need to finance their dollar obligations for trade or international expansion. Chinese citizens from corrupt officials to middle-class workers want to move their money out of the country. They and international speculators have been burned by investments in real estate, corporate bonds, or recently the stock market.
What Will Happen?
“From the Chinese perspective they don’t have any choice anymore, they are stuck. There is no orderly transformation here,” said Snider. Because of inherent problems within the economy and investor losses in every asset class, it seems there is no way back. “They will try to convince market participants that this is the worse and it’s going to get better from here.”
This will be rather difficult, but the Chinese have one supporter: the IMF, which welcomed China to have a more freely floating exchange rate. Of course by freely floating they don’t mean panic crashing and the jury is still out on which one it is going to be.