Wednesday, August 12, 2015

China devalues

The decision by the People’s Bank of China to devalue the Chinese Yuan (CNY) 1.9% against the USD has surprised markets and led to allegations of China joining the currency war.  Those allegations are wide of the mark.

This was, nevertheless a significant move.  This is by far the biggest change in the daily reference rate, the previous biggest move was around 0.4%.  Furthermore  during the last period of managed devaluation in early 2014, the entire adjustment over 4 months amounted to around 1%.

We see this as a timely move on the exchange rate in an economy that needs easier financial conditions for cyclical reasons.  China’s growth challenges are well understood: excess capacity, high real interest rates and an overvalued exchange rate. 

To allege this move as China joining the “currency war” is unfair and wrong.  Yes China is a surplus country, but so too are Japan and the Euro zone and both are pursuing monetary policies that have resulted in significantly weaker exchange rates.  So at least include them in the allegation.

The more relevant point is that in June China’s real effective exchange rate was 14% higher than year ago levels.  That is unsustainable in an economy where the export sector is struggling and the high exchange rate has been a significant contributor to disinflationary forces.

So from our perspective, while this move was a surprise, a lower exchange rate is a timely and welcome addition to the raft of easing measures already in train including lower interest rates, fiscal stimulus and lower reserve ratios for the banking sector.

The authorities have portrayed this move as a one-off move as part of a more market-determined approach to setting the level of the CNY.  That is a firm nod in the direction of the IMF who are considering the CNY’s inclusion in their reserve currency basket.  That requires China to undertake further interest rate liberalisation and allow greater “free-usability” of the CNY.  In that respect this is a step in the right direction.

Markets took this news negatively, however we think it’s a necessary and pragmatic step to ease overall financial conditions to the benefit of the outlook for the Chinese and global economies.