China Weakens The Yuan; Rattles Global Markets

August 27, 2015

On August 11th, the hierarchy of the Chinese Politburo surprised the global financial markets, by unilaterally devaluing the yuan against the US$, without any advance notice. Beijing quickly engineered a -3% devaluation of the yuan against the US$ in two days, in what it called a “one-off” operation. Still, the surprise move sent various financial markets around the world into a tizzy, as analysts, pundits and traders began to speculate that the latest move by Beijing was just the first salvo in a campaign to gradually weaken the yuan against the US$, and possibly, to keep the yuan on an even keel with other major reserve currencies, such as the Euro and the Japanese yen.

Symbolically, last week’s shock move to devalue the yuan signaled the end of China’s “Strong Yuan” policy that began a decade earlier, on July 21st, 2005. At that time, China’s Politburo had finally bowed to massive pressure from the Group of Seven <G-7> countries, (ie; Japan, Germany, France, Italy, Canada, the UK and the US), to un-hinged its currency peg to the US$’s, which had been fixed at a rigid exchange rate at 8.30-yuan, since 1995. After an initial drop of -2.1% on the first day, Beijing engineered a further -16% decline to CNY-6.82 by the middle of 2008. However, Beijing paused the US$’s devaluation for the next two years, and kept the US$ on a tight leash, and until the global economy had emerged from the Great Recession. The US$’s devaluation was allowed to resume in the second half of 2010, until its fell to as low as CNY-6.05 earlier this year.

Beijing adhered to the “Strong Yuan” policy for 10-years, and allowed the yuan to climb by a total of +28% versus the US$. More recently, China’s yuan appreciated by +30% against the Euro, and +65% against Japan’s yen. But now, China is signaling a major shift in regards to the yuan’s exchange rate, under the guise of a more market oriented “flexible yuan” policy. Last week’s sudden devaluation of the yuan was not advertised in advance, and appeared to be a hasty decision. But China’s exports have been contracting for most of this year, and slowing the engine that powers one third of its economy, in large part, because of the yuan’s sharp appreciation against other major foreign currencies, such as the Euro, Japan’s yen, Brazil’s real, Russia’s rouble, the Korean won, and US$. Chinese exported slightly more than $2.3-trillion of goods and services over the past 12-months. The biggest buyers of Chinese goods are the US (17%), EU (16%), Asean (10%), Japan (7%) and Korea (7%).

The central planners in Beijing have attained an almost mythical status. Year after year, Beijing was able to attain growth of +10% or more over a span of two decades, and in the process, transformed China’s economy into the second biggest in the world, while lifting many households out of poverty and others into the middle class. But the mystique appears to be fading. Beijing is trying to rebalance the Chinese economy, to make growth less focused on exports and more reliant on domestic services and consumer spending. It wants slower but more sustainable growth of around +7%. But engineering such a soft landing is proving more difficult than expected. Most analysts agree that China’s official figures are overstating the growth rate of China’s economy. Commodity traders know this to be the case, given the huge declines in the prices of iron ore, coking coal, copper, natural rubber, and crude oil, which speaks volumes about the sharp downturn in China’s economy.

As fears of a hard landing have increased, China’s policymakers have started to panic. In July, Beijing was forced to quickly arrange radical schemes aimed at preventing a meltdown in the local stock market. China’s newly established “Plunge Protection Team” <PPT>, hijacked the stock markets, as the central planners sought to enforce a floor under the Shanghai red-chip market at the 3,500-level. The interventionist measures haven’t restored investor confidence. Professional traders know that China-A shares traded in Shanghai are trading at a +37% premium above dually listed H-shares in Hong Kong.

Still, Beijing is expected to reduce the value of the yuan gradually, in a carefully orchestrated way, as part of its drive to engineer a soft landing for the economy. And for now at least, the PBoC is expected to intervene in the currency markets in order to control the speed of the devaluation, and thereby, avoid making the yuan a big issue in the US’s presidential campaign. After the initial -3% devaluation, the onshore spot price in Shanghai followed a pattern of rallies toward the close, sparking speculation the authorities were intervening. But China’s economy has defied the naturally recurring swings in the business cycle, and has avoided a recession for decades, and if China’s economy weakens further, the country’s leadership may not have the luxury of being able to massage its currency incrementally lower. Beijing might have to opt for a faster and steeper decline to boost exporters, by slashing interest rates and lowering banks’ reserve requirements.

China’s economy is starting to buckle under the “strong yuan” policy. The sudden “one-off” revaluation of China’s yuan caught the world markets completely off guard. However, in hindsight, the pressure that brought about the demise of China’s decade long “strong Yuan” policy, had been developing for quite some time. Most notably, the Euro’s multi-year decline against China’s yuan that began in April 2011. China ships about $30-billion per month, on average to the EU, it’s second biggest trading partner, and the yuan’s rapid rise against the Euro is taking a heavy toll on Chinese exporters. Most recently, the Euro’s slide versus the yuan was greased by the European Central Bank’s <ECB> ultra-easy monetary policy, that ultimately turned to the nuclear option on March 9th – Quantitative Easing <QE-1>, with liquidity injections of €60-billion per month.

As such, China’s exports to Europe were -12% lower in July than a year earlier. Exports to Japan, Hong Kong, and Korea, are also contracting at double digits rates. Output by China’s vast factory sector, which employs tens of millions of workers, is slowing dramatically as demand collapses in its three largest export markets – the European Union (EU), the US, and Japan. With the EU floundering in the swamp of stagnation, caused by austerity; with the US barely growing, and with Japan’s economy sliding back into recession, China’s export growth engine is running in reverse in all three regions. Exports slumped to $195-billion in July, or -8.3% lower than a year earlier. The figures were worse than expected and validated suspicions among private analysts that China’s economy is growing at a far slower rate than the statistics that are conjured-up by government apparatchiks.




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