Beware the Yuan

This may just be the beginning of the devaluation

Probably, most investors do not remember the last time when China devalued its Yuan. It was 21 years ago in 1994, when China shifted from the dual exchange rate system to a unified exchange rate system. It virtually amounted to fixing the black market rate as the official exchange rate. This led to the Chinese Yuan depreciating by 33%. Since then, the Chinese Yuan has been managed deftly in a range by the People’s Bank of China (PBOC). The question is whether the current 2% devaluation of the Yuan could be as acute as the 1994 episode?

China is slowing…

That is possibly the easiest explanation for the Yuan devaluation. An economy that grew at over 10% for over 25 years has suddenly seen growth falling to below 7%. Merchandise exports that had fuelled the rise of China and its forex reserves, were down 8% last month. While it could be partly explained by a global slowdown, it could also be attributed to a strong Yuan. Over the last couple of years, the Euro and the Yen have substantially devalued against the US Dollar due to their easy money policies. China, despite monetary relaxation, did not depreciate much due to its managed floating peg. Therefore this 2% devaluation may be just the beginning in a series of devaluations. While the PBOC is calling it a one-off event, the reality may be much more complicated than that.

It is back to basics…

It appears that China wants to put off its focus on building a consumer market. It also looks like China wants to focus more on export growth rather than on foreign investments. The $4 trillion washout in Chinese markets has, probably, been a hard lesson for the Chinese government. A strong Yuan may have been consistent with China’s efforts to attract more portfolio investments and develop a consumer market. That looks like being put on the back-burner. For now, the focus will be on reviving GDP growth by getting back to the export-driven model. A weaker Yuan surely makes more sense!

China’s exorbitant privilege…

Unlike the US Fed, the PBOC does not have the exorbitant privilege of printing dollars. But China has the exorbitant privilege of the largest dollar reserves in the world. Between 1994 and 2015, Chinese forex reserves have growth almost 80-fold from $52 billion to over $4 trillion. A stronger dollar has the dual effect of spurring exports as well as enhancing the value of its forex chest. Remember, 70% of China’s currency reserves are denominated in dollars.

Back in 2003 and 2004, China learnt the hard way how a weak dollar could create forex losses for China. They seem to be playing the opposite game now. Get ready for more devaluation! ©

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