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Yuan Devaluation: Why, What It Means Now And What Is Next

Business, China, Company Strategy, Europe, Oil & Gas, US
By John Richardson on 12-Aug-2015


By John Richardson

Why did the yuan devaluation take place, and what happens now and over the next few months? Here is my take on yesterday’s announcement.

Although this might not be the main motive behind a move that I predicted would happen in February of this year, a cheaper yuan will provide support for China’s struggling exports at the expense of manufacturers everywhere else.

You might well say, “OK, but China’s decision to adjust how it manages the value of the yuan has only caused it to fall by 1.8% against the US dollar.”

But what if this is the first of several devaluations? You can see why this might be necessary, as the problem for the yuan is that it is pegged against the US dollar. So as the dollar has strengthened as a result of the winding down of the Fed’s quantitative easing programme, the yuan has lost huge ground against other currencies such as the euro and the yen. The New York Times updated this point yesterday, when it wrote:

In the last year, the euro has dropped about 18% against the dollar and against the Japanese yen has plummeted about 22%. 

Demographics are also playing a critical role in China, as they do across all of the global economy. A switch from a demographic dividend to a demographic deficit in China because of the One Child Policy has led to rising labour costs in its developed coastal provinces. This is further eroding its export competitiveness.

Sure, this is a shakeout that Xi Jinping and other key reformers want. They want to get rid of low-value manufacturers that are also wrecking the environment. The aim is to replace them in the developed, eastern provinces of China with high value, and also environmentally responsible, manufacturers of products such as sophisticated smartphones.

But any economic reforms need time – and the time we are talking about is at least five years before these very risky, but visionary and essential, reforms are completed.

Xi is now in a much stronger position thanks to the failure last of month of government intervention in domestic stock markets. This was a policy driven by the anti-reformers, as Paul Hodges pointed out in the latest issue of his  PH report.

Even Xi, though, cannot afford to throw too many people out of work right now as reforms continue, as he first needs to create enough new jobs in services and higher-value manufacturing.

So one way of creating this time is to temporarily boost exports of all the oversupplied goods that China makes by weakening the yuan. And even if there are no further moves to weaken the currency, China simply cannot afford to throw hundreds of thousands of people out work at the moment. This means that they might resort to other export subsidies.

Perhaps a much-bigger reason for the decision on the yuan was, however, to do with capital flight. This was the argument that James Gruber, a Melbourne, Australia-based financial journalist and former fund manager first made in an important research note last November.

All was fine with China’s capital account until 2008, pointed out James, as up until then, China was easily able to fund itself thanks to booming debt-fuelled Western economies.

And from 2008 until the second half of last year year, there was still plenty of hot money flowing into China.

The trouble now, though is that this hot money is going the other way because of the the winding down of the US quantitative easing programme and the prospect of a US interest-rate rise later this year.  Foreign and local investors are also moving money offshore because of a weaker Chinese economy.

In 2015 Q1, this led to the capital account deficit being much larger than the current account surplus. “The sudden shift from monetising large net inflows to monetising little to nothing could not have helped but be stressful for the financial system, and needless to say, there was lots of stress,” a China source told the FT Alphaville blog.

James wrote in November that China would respond in this way to the problem:

Initially, we suspect that China would try to defend the currency by liquidating foreign exchange reserves. That would risk a deflationary spiral, however. It would shrink money supply, reduce credit growth, leading to falling asset prices and further capital flight. 

Remember that this strategy was pursued initially by the Asian tigers in 1997. It was abandoned as it proved too painful. Devaluation was eventually favoured and the Tiger currencies declined close to 60% on average. 

If capital flight were to occur, we believe China would eventually follow the less-painful route of devaluation too.

If other currencies now fall in line with the decline in the value of yuan, you can again imagine that this is just the first of several devaluations by China as it tries to defend its capital account.

What does this all mean then?

  1. China, as I said, has huge oversupply in just about every manufacturing industry and so it has the ability to fill  “bargain basement” stores in the West with even cheaper goods. This will be during a period of history when hundreds of millions of middle class families in the West will be clamouring for ever-cheaper goods, from anywhere and everywhere, because of ageing populations.
  2. And as the chart above shows, China is already exporting deflation to the rest of the world (its producer price index fell by 5.4% in July), along with the Japanese and the Europeans through their wholly misguided stimulus programmes.
  3. So the devaluation will add to global deflationary pressures – and will contribute to further declines in crude oil, back to its historic level of around $30 a barrel.
  4. Chemicals companies might think, “great, we can export more to China as they ramp up manufacturing”. But they will lose customers in their own backyards as China takes more market share in manufacturing.
  5. We might also see greater tensions in international trade.