A Chinese Surprise
Now that Greece has settled down, it is China's turn to upset world markets again. In a surprise move last week, the Chinese government devalued their currency over the course of three days. The yuan ended the week trading at just 6.392 per dollar. That represents a 4.4% drop in currency value — the largest change since the introduction of China's modern exchange rate system in 1994.
US stocks fell during this devaluation, only to rally at week’s end, closing Friday nearly even. Global stocks took similar trajectories. The situation stabilized once the Chinese central bank took action to prop up their currency and reassure markets by dismissing rumors about further large devaluations linked to supporting exports.
Correcting an Overvalued Yuan
For years, the International Monetary Fund (IMF) and US Treasury — along with other sovereign nations and private institutions — have urged China to move toward a floating currency. The Chinese central bank said that is exactly what took place last week, albeit to a smaller degree.
China's currency is still pegged to the dollar. The government sets the target rate against the dollar and then allows trading of the yuan within ± 2% of that mark. Beginning last Tuesday, the midpoint for trading changed from the government-established target to the market's close for the previous day, establishing a controlled float of the exchange rate.
Changing the midpoint enabled an overdue correction. The dollar's value has significantly increased over the past year, dragging the yuan along with it and arguably overvaluing the yuan with respect to other benchmark currencies such as the euro and the yen. Even with the drop, analysts at Goldman Sachs pointed out that the yuan "remains 15% stronger on a trade-weighted basis versus a year ago."
So why all the fuss? Mainly, it’s because nobody expected the move. Moreover, questions about China's long-term intentions are feeding speculation.
One plausible reason for the change is that China is simply trying to stimulate its recently struggling economy. Chinese stocks were hit hard through late June and early July, and Chinese exports dropped 8.3% year-over-year from July's reading. It is possible that China's leaders feel that the economy is too weak to meet the projected 7% growth rate without a devaluation to make Chinese goods more competitive abroad.
Devaluation may also be part of a long-term move to elevate the yuan to the stature of an internationally accepted reserve currency — thus rivaling the dollar. Loosening the government's control is one step toward currying favor with the IMF, which had previously announced a delay until the end of the year on a decision to include the yuan as a reserve asset along with the dollar, pound, euro, and yen.
Expecting the trend to continue at a more orderly pace, analysts at Citigroup are predicting another 4% drop in the yuan's value over the course of the next year. How the Chinese government handles the yuan over next few weeks may help to clarify the reasoning behind their move. Do the moves stop and start in coordination with economic data and growth projections or do they continue in a more controlled fashion to reach a more market-based valuation of the yuan?
Winners and Losers
China's action bodes poorly for companies that compete with Chinese firms or depend heavily on exports to China, thanks to an even stronger dollar. The effect could be multiplied if recent economic weakness in China leads to lower domestic consumption. That would represent a powerful double whammy to sectors like oil, already suffering from a worldwide glut and in desperate need of increased demand to bring up prices.
On the other hand, importers of Chinese goods will be beneficiaries whether the imports are raw materials or finished goods. It's also possible that China's action will cause the Federal Reserve to hesitate on raising interest rates. While many analysts expect the Fed to raise rates next month — and do not think the Chinese devaluation is enough to alter thinking at the Fed — this view assumes China maintains a slow pace for any further devaluation.
In any case, Chinese currency devaluation makes it more likely that the inevitable Fed increase will be limited. In the words of George Goncalves, rates strategist for Nomura Securities, "It will have to be the most dovish hike in history." No one wants an aggressive rate hike to stall the economic recovery.
Whether the Chinese government's reason for devaluation is to begin liberating its currency, to boost exports, stimulate growth, or some other reason, the end is still a stronger dollar. It seems likely that this trend will continue, but at a rate the Chinese government can better moderate and control.
You may have already reviewed and adjusted your exposure to Chinese stocks based on the Chinese stock market plunge. It's time to take that review to the next level, assuming a continually strong dollar and slower Chinese consumption. Do the companies you hold bring in substantial revenue from China? The answers might surprise you.
While many investors know that Yum! Brands, the parent of Taco Bell and Pizza Hut, gets more than half its revenue from China, few would have guessed that Wynn Resorts of Las Vegas fame receives 70% of its income from China. The lesson here is to dig into details, and don't simply assume there is little or no revenue connection to China. That also goes for positive exposure, such as manufacturers that benefit from cheaper Chinese raw materials.
It is always dangerous to predict China's actions or to assign motives to the actions they have already taken. At the moment, a significant amount of the effect on the market is from investors and analysts projecting motives on the Chinese government and extrapolating the effect. Unfortunately, these psychological effects have tangible market consequences.