China Devalues its Currency. Good or Bad?

After an unexpected report of a year over year drop in Chinese exports of -8.5%, the Chinese government, literally overnight, devalued its currency, by just under 2%.  Translation: The Chinese government reduced the value of its currency, which makes the price of the goods it produces cheaper/more attractive to foreign buyers.  For example, a Chinese product that cost a U.S. importer $100 on Sunday cost $98 on Monday.  The intent is to create increased demand for Chinese products, which will stimulate the economy and boost economic growth.

Ascertaining economic activity/economic growth in China is not a transparent process.  It is still very much “what the government says it is”.  The devaluation is another sign/admission by the Chinese government that the rate of economic growth in China is slowing.  Instead of the 8-9% growth rate it had experienced for many years, the growth rate is now thought to be in the mid single digits.  

So, what’s the big deal?  Why have global equity markets had such a visceral negative response?  The issue is that China is now the 2nd largest economy in the world and has been viewed by investors as a key engine of global growth.  A reduction in their growth rate has a noticeable impact on global growth.  To date, China has not allowed their currency (Yuan) to be determined by the market place.  Instead, the Chinese government pegged the Yuan to the dollar.  In essence, the Chinese government had been trying to keep up the appearance of a strong economy, artificially propping up the Yuan which appreciated ~20% in the last year while the underlying economy was deteriorating.   Once the -8.5% decline in exports was announced maintaining appearances was too costly.  Barron’s has reported Chinese monetary authorities were selling some $180 Billion of U.S. Treasury securities between March and May, using the dollars to buy up Yuan and prop up its value.

The devaluation can also be viewed from another perspective.  Despite China being the world’s 2nd largest economy, it does not get the respect one would think the world’s second largest economy would command.  It’s currency and financial leaders do not receive the same respect as other developed markets such as the U.S., Germany, and other G-7 nations.  This is in large part because the Chinese Government does not take the responsibility (as other governments of large economies do) to pursue and maintain a market driven environment.  China very much wants the recognition and prestige associated with the Yuan being part of the IMF’s (International Monetary Fund) SDR Basket of currencies.  The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves.  Its value is based on a basket of key international currencies.  SDR’s can be exchanged for freely usable currencies.  Bottom line, this move, while difficult for markets in the short term, may be positive because it is signaling a greater willingness by the Chinese government to allow the currency to be one step closer to having a currency set by free market forces rather than being controlled by the Chinese government.

All comments and questions are welcome.

Denise M. Farkas, CFA®