Rmb devaluation: start of a freer currency regime 2

Last week, People’s Bank of China (PBoC) surprised the world’s financial markets with the Rmb’s first major devaluation since 1994. There were widespread losses on stock exchanges in Asia, and in Europe, markets suffered falls of about 1%.

Haibin Zhu, economic analyst at JP Morgan, posited two scenarios of how the devaluation had come about: One, that the PBoC had shifted to a new regime where the daily fixing would be based on the actual spot closing rate of the previous day, or two, it was an one-off event and the PBoC would once again go back to fixing the central parity based on its own judgment of market conditions and only with partial reference to the actual spot rate.

He added, “while the regime change is clearly a step forward towards creating a freely floating currency, the transition to such a framework is likely to take some more time and could be volatile. The process will also be influenced by the PBoC actions, including further clarification on policy intension, window guidance or occasional foreign exchange (FX) intervention. If the scenario of a regime change is true, then in the coming days, the PBoC will continue to fix the central parity close to the previous day’s spot closing; the spot rate will trade higher; that will imply an even higher fixing and so on. Where will all this end? When the spot and therefore the fixing rate reaches a level where it is considered to be fair value by both the market and the PBoC.”

Rmb devaluation sparking a currency war in which countries take steps to lower their currencies for competitive reasons is an overestimation of its impact. Traders say the currency is likely to remain under downward pressure as the economy struggles, but do not believe China will further plan a big devaluation or a series of devaluations to boost exports

Immediate impact of Rmb devaluation

Economists pointed out that China gained limited competitiveness from a weaker currency because other currencies also fell in line; Malaysian ringgit was weaker by 2.4% versus the US dollar, the Korean won was down by 2.3% and the Singapore dollar was 2.3% weaker.

South Africa’s currency, the rand, fell to a 14-year low, and its stock market suffered heavy losses. For Africa, this sudden devaluation of  the Rmb is a reminder of the risks of over dependency on China.

India saw this move as a temporary impact on the rupee; it has adequate foreign exchange reserves. However, Indian exports to China will become more uncompetitive and is likely to further widen their bilateral trade gap. Indonesian rupiah will continuously weaken with further drop in the Rmb. With China accounting for more than a quarter of Australia’s exports; Australian companies will lose out with the Rmb devaluation.

This shockwave can also be seen as a deliberate break in the stability they have had for some years with the US dollar. A cheaper Rmb will help Chinese exports by making them less expensive in overseas markets. There’s however a possibility that China will lose control of the currency. But with a high level of state control over the banking system and having more than $3.5 trillion in foreign assets, China currently is not at any significant risk of a debt crisis. The devaluation could also be seen as a response to IMF’s concerns about whether to grant the Rmb reserve currency status and inclusion in the special drawing right (SDR) basket.

Near-term outlook

ING Financial Markets Research commented that two China-induced factors currently drive global FX markets following the surprise Rmb devaluation:

The yuan (Rmb) devaluation and the accompanying negative impact on commodity prices is placing pressure on Asia FX and commodity currencies in general. The Rmb devaluation means stronger Asian currencies on a trade weighted term, in turn prompting speculation that local currencies would “catch up” on the downside. The initial decline in commodity has weighed on commodity prices even outside of Asia.

Next, lower oil prices raise concerns about the path of global inflation, leading the market to scale down expectations of tighter monetary policy. This, coupled with lower US yields, is behind the resilience of the EUR against the USD. In this environment, EUR downside is more limited compared to USD downside given that there is plenty of scope for the market to re-price the Fed’s expectations, while the ECB’s QE is fully under way.

This environment translates into uneven USD movements: Dollar strength against Asia currencies and commodity currencies (provided commodity prices are still under pressure), yet USD weakness against EUR and European currencies as markets expect a lower probability of a Fed funds rate hike in Sep. 

What to expect between now and September

Petr Krpata, FX strategist at ING Financial Markets Research remarked, “Beyond the near-term, the price action in FX markets between now and end-September will be largely a function of: the extent of the yuan (Rmb) and yuan-denominated assets sell-off and whether the subsequent negative spill-over effect in global asset markets (ie, oil and equities) influences the Fed’s September rate decision.”

He continued, “A sharp drop in stock prices globally would be an issue for the Fed as it would negatively affect US consumer confidence and prompt corporates to reign in capital expenditure spending. This would potentially delay the Fed from hiking in September.”