The People's Bank of China Devaluation of the Yuan & FX Effects

Clerk Counts Yuan
Yuan Devaluation Shakes Markets.

Talking Points

What Happened? 

Why? 

Suspected Outcomes

What Happened? 

 

On August 11th, the world was shocked by a move that wasn't priced in and definitely not expected. China decided it was time to devalue their currency, the Yuan, changing their tune from a tightly controlled monetary policy after data showed a slump in trade and other economic indicators. The People's Bank of China decided the strong dollar in their present monetary policy of the off shore Yuan had begun to limit their economic potential.

The Chinese government, who is going through a type of economic puberty, is trying to strike a middle ground that keeps growth in line with goals while preventing doubt both domestically and abroad. The transition where the government finds out whether or not the transition from an economy almost fully reliant on government towards an economy fully reliant on free-trade and market demand is attainable as their demographics set them up to surpassed the United States as the world's largest economy.

Why? 

The People's Bank of China utilize what is known as a "managed float," whereby the yuan fluctuates within a 2% band above or below the reference currency of the US dollar a point set by the People's Bank of China. This is different from other major economies like the JPY, GBP, or EUR to name a few that freely float against the US dollar. The managed float is meant to allow market forces to determine rises or falls yet at the same time prevent some of the more harmful swings like cat's been seen in years past with the CHF.

 

Unfortunately, markets don't always do what governments wish they would do. Typically, or always, you could say the government wishes the economy on a global scale would do whatever benefits the local economy the most. Whether you ask Greece or Germany or Australia or Japan, that often does not happen and governments need to step in to prevent further domestic economic decay.

The current global macro view has seen the USD has strengthen around the world due to the global deflationary crisis and with the managed float, this caused the CNH to strengthen as well. 

Suspected Outcomes

When the world's 2nd largest economy weakens their currency intentionally, 2 questions come to surface. First, is the People's Bank of China done or is it just the beginning? For economic references on a multi-year program to weaken their currency, one only needs to look to China's economic neighbors of Japan or look at the chart of USDJPY in 2011 / 2012 to present day. 

Second, what will be the impact on Global inflation or worsening deflation as one of the worlds largest purchasers from emerging and developed economies purposefully devalue their currency? A quick look at neighboring bond markets show investors, who are forward-looking by nature, are buying local bonds aggressively as China’s yuan devaluation keeps inflation contained and gives central banks a reason to cut interest rates in order to lower borrowing costs, which is intended to boost the economy.

The immediate effect in the week after the devaluation was a continued selloff in commodities. The logic here was that China needed to devalue because demand was decreasing.

Due to China being a key piston of the economic engine in the global recovery since 2009, their actions caused many to fear that commodity demand would continue to decrease causing prices to further slide.

The other stick in the mud to consider is other central-bank plants. Whether you look at the Federal Reserve, the Bank of Japan, the European Central Bank, or many other G-8 central banks, inflation has been in the cross-hairs of their policy goals. China yuan devaluation could make it harder on a global scale to reach their goals. In the last week of August, Japan showed year-over-year inflation at 0.2%, a far cry from the 2% target that day and many other central banks hold. Should inflation stay lower for longer, central banks may engage in new forms of competitive currency devaluation.