Cheaper Chinese Currency Has Global Impact

Aug 12, 2015

Beijing signaled with its currency devaluation that the domestic economic slowdown it has failed to reverse is no longer a problem confined within China’s borders. It is now the world’s problem, too.

Chinese officials have cut interest rates four times in the past 12 months, increased the amount of money banks can lend out and pumped funds into the stock market—measures meant to boost domestic demand in the world’s second-largest economy. By devaluating the yuan, Chinese authorities are turning to a controversial growth-boosting tactic whose effects by their nature reverberate far and wide.

A cheaper yuan could help boost Chinese exports. It also might complicate the Federal Reserve’s decision about when to start raising U.S. interest rates. It will pressure China’s direct trade rivals, such as South Korea and Japan, to follow suit and let their own currencies fall. It raises risks of market volatility in other emerging market economies. More broadly it sends a signal to investors that policy makers in China and elsewhere are straining for tools to address the problem of slow growth.

“This reinforces the narrative from last month’s panic reaction to [its declining] stock market that Chinese officials know their economy is slowing faster than the markets have priced in,” said Adam Posen, president of the Peterson Institute for International Economics. The yuan, he added, might have much further to fall.

 

Chinese officials framed their action as a modest move toward a more market-sensitive currency, something U.S. officials, the International Monetary Fund and others have long sought. China had been propping up the yuan before letting it fall by 2% against the dollar on Tuesday. The currency had appreciated 14% against a broad basket of currencies in the year before Tuesday’s action, straining China’s export sector.

The Obama administration reacted cautiously, with a Treasury Department spokeswoman saying “it is too early to judge the full implications of the change,” but noting that “China has indicated that the changes announced today are another step in its move to a more market-determined exchange rate.”

Mr. Posen said the full global impact of China’s action won’t be known until officials signal in the days ahead whether they are prepared to let the currency fall even further.

If that occurs, it could pose a new challenge for the Fed. A strengthening dollar has put downward pressure on import prices and broader inflation. Fed officials say they don’t want to raise short-term rates from near zero until they are reasonably confident inflation will rise from low levels toward their 2% objective. More upward pressure on the dollar will make that harder to achieve.

Some Fed officials have signaled they are prepared to raise rates for the first time since 2006 at their policy meeting on Sept. 16-17. Taken by itself, the yuan devaluation might not persuade them to wait longer to raise rates. But a deepening yuan drop or other signals—such as recent declines in yields on U.S. Treasury notes and weak U.S. wage gains—could combine to give them pause.

 

“Yuan devaluation is disinflationary as all imports from China become cheaper,” saidZhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management. “There is even less reason to hike in September now.”

Central bankers have been working under a gentleman’s agreement in recent years: They don’t protest when another currency depreciates, as long as it isn’t being pushed down directly and intentionally by rival central bankers to improve their competitive position in global trade.

Still, the exchange rate has been an issue European officials have been grappling with for years. Faced with a stubbornly high exchange rate of the euro in the spring of 2014, European Central Bank officials began warning the currency’s strength could weaken inflation, a condition that typically prompts easier monetary policies.

Subsequent stimulus measures by the ECB—including a €1 trillion-plus ($1.1 trillion) bond-buying plan announced in January—led the euro to weaken more than 20% against the U.S. dollar between August 2014 and its 2015 low in March.

The ECB’s policies reverberated throughout Europe. Faced with a persistently strong Swiss franc, the Swiss National Bank in January abandoned a ceiling it had set on the franc’s value against the euro. It has since intervened in currency markets to keep the franc from rising too much and damaging Swiss exports to the eurozone.

If China’s devaluation deepens, pressure to weaken currencies could become particularly intense in other Asian nations that export large amounts to China or compete with Beijing in other markets. Asian currencies tumbled on Tuesday, notably the South Korean won, Australian dollar and Thai baht, as investors bet China’s move could lead to further monetary easing in those nations. Many Asian nations have cut rates this year and could be forced to take further action in coming months.

“A new theme has emerged—one of Asian currency weakness,” said Wai Ho Leong, an economist in Asia at Barclays.

The pressure for more monetary easing is likely to be intense in South Korea, which increasingly is competing with China in global markets to sell cheap mobile-phone handsets and other goods. Growth in South Korea has been disappointing this year, and the government has relied on rate cuts and a weaker won to support the economy. That hasn’t borne fruit, with exports in July falling 3.3% on year, marking the seventh straight month of declines.

 

A Bank of Korea official said the yuan devaluation was likely to put further downward pressure on the won. The official didn’t say whether the central bank is considering more interest-rate cuts and warned a too-weak won could lead to capital flight.

“A weaker yuan is not a simple but a complex issue that can have simultaneously conflicting ramifications on Korea. We will keep an eye on it,” the official said.

Slow growth was a problem in many emerging markets outside of China even before its move. Domestic demand in emerging economies (which comes from consumer spending and in-country investment, as opposed to trade) grew at a pace of less than 2% in the first half of the year, according to economists at J.P. Morgan. That is half of last year’s pace and less than the pace in developed economies.

Slow growth might call for lower interest rates and currency devaluation in other circumstances. But central banks are so worried about sparking outflows of capital and market instability in some places that they are avoiding doing it.

Bank Indonesia’s senior deputy governor, Mirza Adityaswara, said the yuan devaluation won’t lead to greater weakness as the country’s currency, the rupiah, is already trading at 17-year lows and is undervalued.

Inflation in Mexico is running below its 3% objective. Despite slow growth and low inflation, however, Augustin Carstens, governor of the Bank of Mexico, said in an interview with The Wall Street Journal last week he was prepared to raise interest rates to keep markets and the currency stable.

“We have prepared ourselves to pretty much adjust interest rates when [U.S.] liftoff takes place,” he said.

 

Source: The Wall Street Journal