China’s monetary authority took the markets by surprise last week, allowing its onshore currency (CNY) to weaken roughly 3% against the U.S. dollar. Western markets, media and certain U.S. congressional officials were quick to cry foul, suggesting China was devaluing its currency to gain an edge – a deliberate act of currency war. In fairness, the timing was suspect, coming days after very weak export numbers and amid concerns of an economy slowing down too quickly.
The real story: a 3% selloff is a weak attempt at devaluation. This is more evident if you consider that the EUR is 9% lower year-to-date, commodity currencies (e.g. CAD, AUD, NZD) are down 10-15% vs USD, and emerging markets are 10-20% lower. Chinese policymakers have proven to be tactical and calculated. If they wanted to create meaningful economic stimulus via currency depreciation they would have moved CNY far more than 3%. This was not a stimulus driven move and the People’s Bank of China (PBOC) has warned not to expect further currency related measures. In fact, relative to a broad basket of more than 30 major currencies, the CNY still ranks as the sixth best performer relative to the USD year to date.
Currency revaluation rather than devaluation
China has been working with the IMF to gain inclusion to the Special Drawing Rights (SDR) (currently made up of EUR, GBP, USD and JPY) this year. The shift to a freer-floating currency, still within previously established 2% trading band, is an attempt by China to show willingness to meet required parameters for SDR inclusion. In order to shift from a pegged currency to a floating currency, within a 2% band, Chinese authorities had to take some form of action. This action was an attempt to allow the currency to “revalue” itself at something closer to fair value. The jury is still out on what true fair value for CNY should be. It is a question that won’t be answered until capital is able to move freely, allowing demand and supply to determine fair value over a reasonable period of time.
While it is our core view that the PBOC decision was a shift towards currency liberalization, the market’s interpretation and response are ultimately most important. The market does not pause to think whether it is devaluation or not – it just reacts. Last week’s 3% loss, the largest since the 33% devaluation in 1993-94, was enough to spur a broad wave of market reaction.
The CNY move did catch the market off guard causing a spike in market volatility. Asian currencies came under severe pressure. Many, including the Malaysian ringgit, New Taiwan dollar, Indonesian rupiah, South Korean won, Singapore dollar, Indian rupee, Thai baht and Philippine peso experienced a significant spike in implied volatility. Although some calm has returned, volatility and concern remains elevated. Coincidentally, the broad basket of Asian currencies weakened materially against the Japanese yen as well. Within the Asian trade corridor, the Bank of Japan’s QE program has helped Japanese exporters at the cost of other Asian-based producers. Last week’s move by China helped rebalance that discrepancy in a minor way.
Insight on how the CNY peg is achieved
In order to control currency volatility, a maximum 2% daily trading band has been in place for several years. Each day a fixing rate is announced, providing an anchor for the currency’s value. The peg has been very closely managed via the onshore interbank market – also generally kept within several basis points of the last fix. The interbank market is limited to roughly 30 authorized banks, all dealing via the Chinese Foreign Exchange Trading System (CFETS). The closed electronic system is controlled by Chinese authorities, meaning they have the ability to accept/deny prices going to market. They can also enter the market themselves to defend certain levels – thereby managing the fixing rate and trading range. This practice will not likely disappear anytime soon, but the ability for the currency to sway back and forth within the 2% band will increase, relative to recent years.
The CNY move appears to be unrelated to China’s stock market and economic woes. The economic slowdown underway in China would need a currency devaluation larger than 3% to have a meaningful impact – think more along the lines of 15-20% at minimum (which may be the plan over the medium-term). For now, this seems to be a policy shift with a view to the long-term, not a short-term economic policy tactic. Nonetheless, China is facing strong economic headwinds and deflationary pressures are mounting. Forget currency wars, trade wars are on the horizon if China and the global economy fail to find stable footing.