Saturday, August 15, 2015

Making Sense of China’s Currency Devaluation

Making Sense of China’s Currency Devaluation
Published Fri, Aug 14, 2015  |  Alan Gula, Chief Income Analyst

Yuan Devaluation: Making Sense of China’s Currency   

Earlier this week, two massive explosions rocked the Chinese port city of Tianjin. It’s said that the larger explosion was equivalent to over 20 tons of TNT being detonated. The blasts were so large that seismic activity was registered around 100 miles away.

The exact cause of the explosions is unknown, but other shocks emanating from China have clearer triggers.

On August 11, 2015, China devalued its currency, the renminbi (yuan), by 1.9%. It was the currency’s biggest one-day drop since 1994.

It didn’t stop there, either. At one point the following day, the yuan had cumulatively lost as much as 3.9% of its value against the dollar. Policymakers in China seem to be following through on their promise to allow the market to play a bigger role in determining the exchange rate.

“A fixed exchange rate looks stable, but it hides accumulated problems,” noted Yi Gang, Vice Governor of China’s central bank.

China doesn’t have a fixed peg, but it does heavily manage the yuan’s level relative to the U.S. dollar. The chart below helps us put the devaluation into perspective. The y-axis has been inverted so that a rising line shows yuan strength.

U.S. Dollar (USD)/Chinese Renminbi (CNY) Exchange Rate

As you can see, China allowed the yuan to significantly appreciate against the dollar from 2005 up until the credit crisis. The fixed peg was reinstituted from mid-2008 until mid-2010. Then, the yuan began a slower appreciation, which culminated in early 2014.

So, the yuan’s relatively small recent devaluation has only given back a small portion of its longer-term appreciation. That said, we shouldn’t downplay what’s happening right now.

The U.S. dollar bull market has really forced China’s hand. The dollar has been very strong over the past year against virtually all global currencies. Therefore, the yuan has been dragged higher. With a strong currency, China has lost some of its export competitiveness. China has also been burning through foreign exchange reserves to keep the yuan at a level above where it would naturally be.

Given that China’s economy is slowing, its exports are flagging, and its speculative bubbles are collapsing, the move wasn’t completely unexpected. Plus, an increasingly market-driven exchange rate will pave the way for the yuan to enter the Special Drawing Rights (SDR) basket.

Nonetheless, the market seemed to be surprised by the devaluation. Global equity markets dipped and the U.S. 10-year yield declined all the way to 2.05%.

China’s move has sparked fears that a new wave of deflation will wash over the world. A weaker yuan will also help boost China’s exports at the expense of other nations. Koichi Hamada, an adviser to Japan’s Prime Minister, went so far as to say that Japan can offset the yuan devaluation with monetary easing.

Indeed, it’s clear to see why there’s a risk of escalating competitive devaluations or “currency wars.”

For individual investors, it’s important to take a step back. Just a little while ago, Greece and Europe were roiling the markets. Now, it’s China’s turn. Soon, there will be something else.

If you’re getting spooked by these news-driven stock market plunges, only to buy higher after a fierce rally, you’re doing it wrong. Many traders and investors are simply getting whipsawed by the volatility. Meanwhile, the S&P 500 has effectively gone nowhere since the Fed’s latest quantitative easing (QE3) program ended.

This is why everyone should hold globally diversified portfolios of stocks, preferred stocks, bonds, and real assets. There are going to be more (and much larger) disturbances down the road, and their timing is uncertain. By being properly diversified and intelligently taking on risk, you’ll protect yourself from the market shocks and volatility storms coming our way.

Safe (and high-yield) investing,

Alan Gula, CFA

Editor’s Note: Speaking of protecting yourself, we’re on the verge of launching a one-of-a-kind research service that will show you how to navigate today’s treacherous environment. It’s called The Shockproof Investor, and it’s designed to help mitigate risk while taking advantage of current market conditions. You can sign up here to reserve your spot (for free), and we’ll send you everything you need to know as soon as it’s ready.
As Wall Street Daily's Chief Income Analyst, Alan is continually and fervently analyzing the financial markets. He draws upon a wide range of finance experience, including investment banking, research and trading. Learn More >>

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