Policy, China

China's Exchange Rate Policy: Separating News from Noise

August 12th, 2015 | By Nick Sargen

Highlights

  • Global markets have reacted strongly to China's announcement that it will let market forces play a greater role in determining the value of the yuan. News reports have portrayed the action as a devaluation that could lead to a bout of "currency wars." Such reporting in my opinion is pure noise.
  • The more important issue is how much China's economy is slowing. Our base case is the economy is on a controlled glide from 7% to 5% growth, which is largely priced into markets. However, China's economy could turn out weaker, which would send ripples across global markets, especially emerging economies.
  • Meanwhile, we are maintaining our investment strategy of over-weighting credit risk in fixed income and higher-quality names in equities.
 

Implications of China's New Exchange Rate Policy

The Bank of China surprised market participants yesterday by announcing that it would allow market forces to play a bigger role in determining the value of the yuan. Previously, the central bank set the value of the yuan against the dollar and allowed it to fluctuate in a narrow range around a central parity. Going forward, the authorities will set a reference rate for the yuan based on the market's previous close and they will allow the currency to trade in a 2% band around the rate. When the yuan depreciated by 1.6% on the first day of trading, newspaper accounts declared that it was the largest devaluation of the yuan in more than two decades and that it threatened to set off a "currency war" if the yuan continued to slide. The lead story for the Financial Times, for example, carried the headline "China Risks Clash with US", while the Wall Street Journal's read "Strains Mount After Chinese Devalue Yuan."

In my opinion, such reports are grossly misleading. First of all, since November of 2013 the stated policy of the Chinese Government has been to allow market forces to play a "determining role" in pricing for financial markets including interest rates and the value of the yuan – a stance the US Government has long favored. Secondly, most newspaper accounts failed to point out that the Chinese authorities at the same time announced they were allowing market forces to play a greater role in setting domestic interest rates, which is consistent with the blueprint for market reforms. And while some observers contend the latest currency action is merely a smokescreen for China to depreciate its currency, it should be noted that the Chinese authorities sold dollars today to prevent the yuan from weakening below its band.

From my perspective, claims about "currency wars" may help sell newspapers, but they do little to educate the public about what is really happening.[1] It is one thing for a central bank to intervene regularly in the currency market to drive its currency lower – which China is not doing – and another for the currency to depreciate when monetary policy is being eased – which China is doing. If the U.S. government had a problem with this, then one needs to ask why it has not objected to a 35% depreciation of the Japanese yen over the past two years. The reason: In the current environment of weak global growth, the U.S. government wants Japan and China to take steps to bolster their economies, and it will not object if such actions weaken their respective currencies.

The bottom line is that it is too early to form a strong conclusion about how much the yuan may depreciate, because the outcome will be heavily influenced by how China's economy fares. Our base case assumes that the growth trajectory is likely to slow from 7% to 5% growth over time, which we believe is mostly priced into markets. The main risk is that China's economy could turn out to be weaker than expected, in which case commodity prices and global asset markets, especially emerging economies, could sell off further.

That said, I view the modification in the country's exchange rate policy to be a tool that gives China's policymakers added leeway to maneuver in a weak economic environment. While it could also cause some in Congress to complain that China is "manipulating its exchange rate," I trust wiser heads will prevail and do not foresee an outbreak of protectionism. In the meantime, we are monitoring the situation closely, but have not altered our investment strategy.


[1] The term was coined by Brazil's Finance Minister two years ago, when he argued Brazil's currency was too strong because the Fed was keeping interest rates too low. Today, the real has depreciated by 50% against the dollar, and Brazil's Central Bank has had to boost short term interest rates to 14% to stabilize the currency.