Devalued Yuan stirs markets

Devaluation of the Yuan is a Chinese effort to stimulate an economy that is growing less rapidly than its potential. Although China is not in recession, its growth rate has slowed down inexorably. The devaluation will help, but don’t expect any immediate miracles. Macroeconomic factors at play do not look too favourable for the Chinese economy right now. The official statement from the People’s Bank of China reads like something erstwhile Federal Reserve chairman Alan Greenspan might have written during the beginning of the subprime crisis of 2007. The gist of the statement is that they will let the yuan float against other currencies to some extent. The Chinese yuan was pegged from 1994 until mid-2005 at 8.28 yuan to the US dollar. China shifted in 2005 to a policy of loosely pegging the yuan to a basket of major currencies. 

It is a fact that currency market intervention has no real effects due to the long-run neutrality of money – prices in a country that devalues its currency will adjust so that the real effects of the devaluation and implied price changes cancel out, leaving import and export volumes unchanged. Nevertheless, a devaluation in this environment is equivalent to the imposition of a tariff on all imports and a subsidy to all exports. Just as with the devaluation, the tariff-cum-subsidy policy leads to price adjustments that cancel each other out and leave import and export volumes unchanged. 

The 2% devaluation by the Peoples Bank Of China (PBOC) has sent shock waves through the Chinese markets and indeed global markets. There are a number of implications of this move. Despite all the cheery talk in the press release about market orientation this move reeks of desperation to jump start an export market falling faster than a corrupt communist party official jumping to his death. This move reveals profound concerns about the state of the economy. While the PBOC is trying to sell this as a model-based readjustment to better align with market prices, the reality is it is opening itself up for further devaluation pressures. The biggest currency risk here is that by resetting expectations on the Renminbi to the Dollar, it is creating future expectations of devaluation. The PBOC can talk all day about market conditions and their models, but markets don’t like to be surprised and the PBOC has just created future expectations.  It will be very hard for the PBOC to put this genie back in the bottle.  This is going to hit a lot of companies hard, companies such as real estate developers and Local Government Financing Vehicles foreign currency bonds.  While the general perception is true that overseas borrowing is not a large part of China’s credit, certain sectors are heavily exposed and you can expect those bonds which are already in high-risk sectors with little onshore legal recourse, to see real hits.

It should come as no surprise that this is announced a day after awful trade data. Don’t think the two aren’t related. The plunge in emerging-market currencies will come under only greater pressure, placing further downward pressure on prices throughout emerging and developed markets. This is likely to hit the Indian markets hard as well. The crisis will emerge when the Fed raises rates channeling capital out of China and other emerging markets. In other words, the real turbulence is yet to come. The market is unlikely to be satisfied with 2% and the PBOC just reduced its credibility by surprising the market. In the short run, with sticky prices, a devaluation will have real effects, but these effects – and hence the translation of a devaluation into trade-policy equivalents – depend importantly on how internationally traded goods are priced. Moreover, the impact of trade policies such as tariffs in a sticky-price environment can be quite different from the impact of tariffs in the long run. But as John Maynard Keynes once remarked in the long run we are all dead.