What China’s currency move could mean for your portfolio

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China’s move to let its currency, the yuan, slide by some 3% to 4% against the US dollar has potentially huge ramifications for investors’ portfolios, even if the move itself can hardly be described as huge. The yuan has gently appreciated for more than a decade although that process may now have come to a halt.

Chinese’s currency fall against the dollar has been very modest so far

Chinese’s currency fall against the dollar has been very modest so far

Source: Thomson Reuters Datastream

Note also how the yuan has gained against key trade competitor currencies such as the Japanese yen and Korean won over the past few years. It is unlikely that this month’s minor moves will give a sufficient boost to the competitiveness of Japanese exports on their own.

The yuan has made huge gains against the Japanese yen

The yuan has made huge gains against the Japanese yen

Source: Thomson Reuters Datastream

The key question is what happens next. The People’s Bank of China (PBOC) held a press conference (13 Aug) to assert that no further action was planned but as Whitehall mandarin Sir Humphrey Appleby (echoing a quote first attributed to the nineteenth-century German chancellor Bismarck) used to advise the hapless Jim Hacker in the seminal 1980s television series Yes, Prime Minister, “You should never believe anything until it has been officially denied.”

If the yuan is devalued in a more dramatic way, mid-August’s market action could be a useful pointer as to what may happen and what investors must therefore consider:

  • Government bonds rallied, especially at the long end, as clients sought protection from a possible deflationary shock caused by China using a cheaper currency to export its way out of trouble
  • Junk bond prices fell hard especially in the USA since any deflationary downturn would hit heavily indebted firms particularly hard, increasing the value of their liabilities in real terms
  • Equities stumbled, particularly across emerging markets and sectors such as commodities and energy, amid fears of a real slowdown in China and again concerns over exported deflation
  • Raw material prices continued to slide, notably oil and copper
  • Emerging market currencies took a pasting. Counters ranging from the Malaysian ringgit to the Russian rouble to the Mexican peso as fell sharply as investors with long memories remembered how 1994’s China devaluation preceded a massive Asian currency and debt crisis by just three years.

If China does act again this may be a useful template for portfolio builders. It is unlikely Beijing will move precipitately – many high profile members of Congress in America has long railed against China as a “currency manipulator” and no-one really wants a prolonged slanging match that could escalate into damaging trade sanctions. China is likely to move and move carefully but when it does, it will doubtless point the finger at the market and argue it is currency traders who are calling the shots, not them. After all, the PBOC’s statement asserted the shift merely represented a one-time adjustment, it also carefully noted currency levels would be set “in conjunction with demand and supply conditions in the foreign exchange market and exchange rate movements of the other major currencies.”  America, champion of the free markets, could hardly complain about that.

Currency conundrum

There are three schools of thought as to why China this month initiated its biggest shift in currency policy since 1994’s devaluation.

  • Sinophiles argue China’s decision to slowly let the yuan float is part of Beijing’s master plan to open up its financial markets to foreigners. Two key steps here are getting its currency admission to the basket of counters which form the basis of the International Monetary Fund’s Special Drawing Rights (SDRs) and entry into key regional global and equity indices. China has missed out on both goals in 2015 but a G20 summit slated for late 2016 in the country would be a good venue for SDR entry.
  • Doubters counter that the currency switch is a panicky policy designed to boost growth at a time when exports are sliding and overall GDP growth is struggling to meet the 7% target laid down by the Communist Party. The yuan is in effect pegged to the dollar and given the greenback’s strength and the prospect of an increase in US interest rates Beijing will not want to see its counter dragged higher by a rampant buck.
  • The Communist Party has made a mess of it, allowing a stock market bubble to form and then burst and then altering its currency policy in a manner that is not decisive enough to help on either of the two counts above.

The third view seems harsh, as President Xi Jinping and Prime Minister Li Keqiang are doing much that makes a lot of sense, including financial reform, a root-and-branch assault on corruption and a move to rebalance the economy away from construction and exports to consumption and foreign direct investment. Nevertheless the minor shift in the yuan does not seem in any way adequate to convince the IMF China is truly embracing the free market, given the controlled nature of the drop or to boost the slowing economy. Further declines in the currency seem inevitable, despite what the Chinese authorities may say, especially in light of how other major currency devaluations have developed.

In 1992, a debt-fuelled property bubble popped and dragged Sweden into a deep recession, taking the krona with it. The currency fell by almost 40% against the dollar in three months and then kept on falling for another year. As an aside, the Norwegian krone and Finnish markka were devalued shortly after, in a domino effect. Finland’s economy had suffered badly from the collapse of the old USSR, a major trading partner.

The Swedish krona was devalued in 1992

The Swedish krona was devalued in 1992

Source: Thomson Reuters Datastream

Also in 1992, the Conservative Government of John Major let the pound fall out of the Exchange Rate Mechanism as a recession rendered sterling’s peg to 2.95 deutschmarks untenable. Sterling plunged to 2.67 against the mark and ultimately shed a quarter of its value against the dollar in barely three months.

The pound fell out of the Exchange Rate Mechanism in 1992

The pound fell out of the Exchange Rate Mechanism in 1992

Source: Thomson Reuters Datastream

In 1997, a debt crisis tipped a string of Asian currencies over the edge. The Thai baht, South Korean won, Malaysian ringgit, Indonesian rupiah and Filipino peso were all crushed in ensuing melee as their governments and corporations were overwhelmed by their foreign currency debts. The baht and won halved against the dollar.

The Thai baht halved against the dollar in 1997

The Thai baht halved against the dollar in 1997

Source: Thomson Reuters Datastream

The Korean won also halved against the dollar in the same year

The Korean won also halved against the dollar in the same year

Source: Thomson Reuters Datastream

Here the markets well and truly took charge and the results were dramatic (even if, remember, many of those counters recaptured most, if not all, of the losses over the following decade). China itself devalued in 1994 and the movement was far greater than that seen this month, as the official yuan/dollar rate tumbled by some 50%, even if the fall relative to the real (black market) rate was less dramatic.

Emerging problem

This devaluation preceded the 1997-98 Asian debt crisis and this is why emerging market equities and currencies are taking a battering, as someone, somewhere fears a repeat.

In the mid-1990s, financial market deregulation attracted tidal waves of cash to Asia’s so-called Tiger economies and banks sucked up the cash and then liberally loaned it out, with rampant real estate and stock market speculation the unfortunate result. Alas, overseas investors finally to twig that growth was slowing, debts were accumulating and balance of payments ledgers were deteriorating, all give-aways that something was wrong. They began to withdraw cash, leaving Thailand in particular unable to service its borrowings, much of which were denominated in foreign currency. As the baht slid lower, this problem only became more acute, as the value of the debts rose in local currency terms and then can the final smash.

The good news is Asian governments still remember the crushing austerity imposed by the International Monetary Fund (IMF). The bad is corporations appear to have forgotten, with a recent piece in the Financial Times pointing out that the emerging market corporate bond (debt) doubled in size between 2008 and 2014 to $6.8 trillion, taking non-financial sector company debt from 60% to more than 80% of GDP in the process.

Dollar dealings

Despite such concerns, it is the yuan’s relationship with the dollar which is probably exercising the minds of policy makers in Beijing the most. Although the official peg abandoned in 2005, the yuan still only trades in very tightly controlled daily bands against the buck. As this column has referenced before, the US currency is on a roll and looks to be embarking upon is third major bull run since President Richard M. Nixon smashed up Bretton Woods and took the dollar off the gold standard in the early 1970s.

History suggests the dollar could rise further, especially if the Fed raises rates

History suggests the dollar could rise further, especially if the Fed raises rates

Source: Thomson Reuters Datastream

The 1978-to-1985 bull run sparked a debt crisis in Latin America while the 1992-to-2001 surge exposed the fault-lines in Asia’s finances, as already outlined above. This may explain why the dollar and emerging market equities seem to have an inverse relationship, as the chart below suggests:

Emerging markets and the dollar have an inverse correlation

Emerging markets and the dollar have an inverse correlation

Source: Thomson Reuters Datastream

The dollar may look strong, at around 92 on a trade-weighted basis, but the buck reached 113 in 2002 and just short of 150 back in 1985, before the Plaza Accord struck by the G5 unilaterally devalued the greenback against the German deutschmark (as it was then) and Japanese yen. If the Fed does raise interest rates, the dollar could therefore go a lot higher and China is doubtless giving itself room to take evasive action – even if the US central bank continues to pussyfoot about.

In the final analysis, China appears to be pulling whatever strings it can to keep its economy ticking along. The law of large numbers means it will not – cannot – grow at 7% a year for ever but the reforms underway should provide it with a better long-term foundation. The short-term problem remains debt as so much of China’s recent progress has relied upon it.

China’s debts have mushroomed in the past decade

China’s debts have mushroomed in the past decade

Source: McKinsey

A February report from consultants McKinsey entitled Debt and not much deleveraging reveals the details. Beijing’s debts have soared from 120% to around 260% of GDP in barely seven years and growth in borrowing has massively outpaced growth in output, which is not a good sign (as Thailand’s mid-1990s experiences attest).

Debt therefore remains the elephant in the room and not just in China either. Global growth remains slow and fragile, not helped by huge debts. The same McKinsey survey revealed global borrowings were $57 trillion – or 42% higher – in 2014 than they were in 2007, when the Great Financial Crisis hit home.

The globe is still groaning under the weight of its debts

The globe is still groaning under the weight of its debts

Source: McKinsey

The interest payments on this paper is sucking away cash that could be used for more productive investment and until this issue is tackled, the markets may find themselves prey to further deflationary shocks. The fascinating bit then will be how central banks react as interest rates are already at record lows and the US and UK have stopped adding to their Quantitative Easing (QE) schemes, and whether markets again show faith in their bag of monetary tricks.

Russ Mould

AJ Bell Investment Director


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Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.