What a Cheap Yuan Means for the Rest of the World

August 16, 2015 Updated: August 19, 2015

China’s central bank temporarily allowed a bigger float for its currency, sending the yuan crashing last week until stabilizing Friday, Aug. 14.

Beijing’s decision to loosen the reins on its currency, the renminbi (yuan), versus the dollar last week jolted the financial markets, especially in South and East Asia. United States and European markets also slumped due to uncertainty over China’s handling of its economy, and resulted in the pessimistic outlook on commodities.

Economists believe continued devaluation of the yuan could be in store. Here we examine how a weak yuan impacts a few pockets of the global economy.

Commodities Will Continue to Slump

Already reeling on a Chinese economic slowdown, global commodities prices will likely decline further on a depressed yuan.

The Bloomberg Commodity Index, which tracks the valuation of a basket of commodities including gold, crude oil, and natural gas, declined 28 percent in the last 12 months.

Since Aug. 10, the index has dropped 2.4 percent.

China is the primary importer for raw materials such as iron ore, copper, and crude oil.

A weak yuan increases the cost of such imports, forcing Chinese manufacturing and construction firms to cut back on spending.

Another factor exerting downward pressure on commodity prices is the dollar. As the world’s biggest reserve currency and—most likely—the one that impacts the yuan the most, any further devaluation of the yuan will further boost the dollar. Since most commodities such as gold and oil are priced in dollars, a strong dollar will further drag down commodity prices.

And that could be bad news for commodity-dependent economies such as Australia, Brazil, Russia, and the Middle East.

Complicating the Fed’s Decision

All summer long, Wall Street had expected the Federal Reserve to raise interest rates next month for the first time in almost a decade. Fed Chair Janet Yellen laid the groundwork last month that conditions are ripe for a rate hike—citing a strengthening U.S. economy, solid consumer spending, and stable employment levels.

Last week, Beijing put a wrench in those plans.

China is one of America’s biggest trading partners. A weak yuan cheapens Chinese imports and overvalues U.S. exports, stirring up deflation fears again and heightening revenue concerns for U.S. multinational corporations.

Yield on 10-year Treasurys dropped 10 basis points between Aug. 10 and Aug. 12 before rebounding by Friday to 2.20 percent, signaling that traders expect the yuan to be a factor in the Fed’s decision-making process.

In the end, the Chinese currency may not change the Fed’s conviction if it believes U.S. economic fundamentals are strong enough to warrant a rate hike. While J.P. Morgan analysts believe a rate move is still in the cards for September, Goldman Sachs Chief Economist Jan Hatzius sees “more fundamental reasons why the Fed may want to wait past September” for a rate hike.

Retail and Luxury

Foreign multinationals dependent upon China sales will likely see a sales decline.

Several factors contribute to this. First, foreign goods will become more expensive to Chinese consumers, putting pressure on sales volume. Second, any revenue generated in China will be worth less for companies reporting earnings in dollars, due to foreign currency translation.

Luxury goods makers will be especially hurt by a weak yuan. Already squeezed by Xi Jinping’s anti-graft and corruption campaigns, foreign luxury brands could see further pressure on sales inside China as well as those from Chinese tourists abroad.

Investors sold off stocks of luxury goods makers last week. Shares of LVMH Moët Hennessy Louis Vuitton fell 8 percent on the Euronext exchange, BMW AG declined 6.4 percent in Frankfurt, and shares of Richemont SA dropped 7.4 percent in Zurich last week.

But companies that outsource to China could see an opposite effect, as Chinese-made finished goods, which are invoiced in yuan, will become less expensive.

“General merchandise retailers and the toy industry will be clear winners,” Fitch Ratings said in a research note last week.

What About Asia?

A weak yuan will have the most negative impact on countries that have a similar export profile to China, and which also exports their products to Chinese consumers.

“In Asia the countries that stand out on those criteria are Korea, Taiwan, and Malaysia and to a lesser extent Thailand as well, from an export similarity perspective,” Credit Suisse Head of Emerging Markets Fixed Income Strategy Ray Farris told CNBC India. “So, these are countries where if the Chinese yuan continues to depreciate, competitiveness pressures and increase in cost in the Chinese market will hurt most.”

Some analysts expect other Asian economies to devalue their respective currencies to maintain competitiveness with China, raising specters of an Asian currency war. Last week the Korean won, the Malaysian ringgit, and the Indonesian rupiah all fell against the dollar.

The reality is a bit more nuanced than that. Take Japan, for example, where the impact of a devalued yuan gives rise to both opportunities and threats.

One could argue that Japanese small businesses and retail stores, on the surface, could suffer from fewer Chinese tourist visits. But given China’s strong middle class and Japan’s close proximity to China, a weaker yuan might increase the influx of tourists to Japan as consumers cut back on more ambitious—and costly—trips to Europe or North America.

For Japanese manufacturers and automakers, China’s general economic slowdown hurts them more than a few percentages of currency devaluation. And if a weaker currency can prop up China’s manufacturers and its economy as Beijing hopes—which is debatable—the resulting increase in sales to China will more than offset the impact of currency.

Japanese firms selling domestic goods have the most concerns, as a cheap influx of goods from China offers fresh challenges to local companies. “There is concern that a weaker yuan could affect the Japanese market in terms of imports from China,” Tatsuro Kanno of Kobe Steel told AP.

And for embattled Prime Minister Shinzo Abe, China’s moves simply give him more leverage for further monetary easing.