China's Yuan Devaluation: Key Implications
The People's Bank of China (PBoC)'s decision to set the CNY midpoint 1.9% weaker against the US dollar (from CNY6.210/USD to CNY6.327/USD) marks the largest one-day fall for the yuan since 1993, and increases the downside risks to the currency. While a 1.9% move is minor by comparison to many emerging markets, for China it is huge, and also hugely symbolic. The risk now is that investors will see the yuan as a one-way bet weaker and start to position against the currency, raising the prospect of more substantial yuan weakness and more economic uncertainty.
- Devaluation Not Large Enough To Support Competitiveness
- Likely To Create A Sense That Weakness Is A 'One-Way Bet'
- Export Slump And Deflation Show Downside Pressures Mounting
The August 11 devaluation in the yuan is not large enough to improve China's export competitiveness, but it is large enough to create a sense that Beijing may have fundamentally shifted its currency policy, which could set in motion a shift in sentiment towards the renminbi, resulting in considerable further weakness. While the People's Bank of China (PBoC) was quick to emphasise the one-off nature of the move, this is unlikely to be seen as a credible statement.
China's export data for July showed that the 16.0% real effective appreciation of the currency over the past year is having a negative impact on competitiveness, at a time when domestic economic growth drivers are also weakening. The PBoC acknowledged that the yuan's effective exchange rate was stronger than its trading partners, but we believe that a 1.9% move is unlikely to address this concern, raising the prospect of further downside moves. Similarly, Beijing is concerned with the potential for deflation, with producer price inflation falling to -5.4% year-on-year (y-o-y) in July. Again though, a 1.9% fall in the yuan is unlikely to assuage this, and may in fact intensify deflationary pressures as uncertainty and cash hoarding increases.
We previously argued that Beijing's all-in response to the equity market crash raised the downside risks for the currency. Indeed, we stated on July 15 (see 'Headline Growth Beat Offers Little Cause For Cheer') that "the loss of control of the equity market is a reminder that market can overwhelm even the Chinese government on occasion, and as Beijing looks to further liberalise its financial account, the risk of sudden capital outflows is increasing". Additionally, we argued on July 31 (see 'Financial Stability At Risk: Global Implications') that "the risks of a devaluation (greater than 10% rapid move lower) are growing".
The re-setting of the CNY midpoint has heightened these concerns, and also raised downside risks to the economy. Increased uncertainty among domestic and foreign investors over the trajectory of the yuan is likely to delay investment decisions, further undermining China's already-fragile economy.