World

China’s monetary explosion that rocked the world

By J Brooks Spector 17 August 2015

China’s two unexpected explosions – the massive inferno at the Tianjin port and warehousing area and the sudden and unanticipated devaluation of the yuan or renminbi – caught the world by surprise. The Tianjin incident may have revealed yet another chink in a less than comprehensive environmental and pollution control regimen, but the sudden currency devaluation has roiled the waters of the global economy – and its ultimate impact is still unclear. J BROOKS SPECTOR takes a closer look.

This past week, a major explosion rocked China. Actually, there were two of them. The first, and the one that garnered most of the media attention was that massive blast in Tianjin, one of China’s major port cities. Tianjin’s vast warehouses and shipping storage areas contained huge quantities of a mix of extremely toxic, dangerous, poisonous chemicals. When the explosions ripped through those storage areas and warehouses, the resulting disaster sent a fireball hundreds of meters into the night sky recorded on many cellphones and video cameras – and those images quickly found their way into the global media stream.

Hundreds of people were killed or wounded, and many others remain missing. Fire fighters often battled the blazes using pressurised water that simply spread the burning chemicals further, rather than more sophisticated chemical fire suppressing agents. Days later, the damage and death toll continues to grow, a large exclusion zone has been declared, and the disaster has refocused world attention on weak Chinese pollution controls as well as the apparently lackadaisical handling of dangerous materials used in the country’s rush to riches.

Meanwhile, yet another, entirely different explosion also went off in China last week. This was a totally unexpected financial and monetary one as Chinese monetary authorities suddenly engineered a downward valuation of the yuan or renminbi by close to 4% against the dollar over a three-day period.

Explaining how the Chinese government actually makes such decision on the yuan’s value, rather than let it float freely as with other major currencies, the Economist explained: “Every morning, market makers such as the big state-owned banks submit yuan-dollar prices to the People’s Bank of China (PBOC, the central bank). It then averages these to calculate a ‘central parity’ rate, or midpoint. Over the course of the day, the PBOC intervenes to keep the exchange rate from straying more than 2% above or below the midpoint. In theory, it is the market makers, not the central bank, that set the midpoint and thus the trading band. In practice, the PBOC gets market makers to submit rates that will yield its preferred midpoint, irrespective of market sentiment (state-owned banks are pliant, after all). Critics in America and elsewhere have long alleged that China has manipulated the market in this way to keep its exchange rate cheap. They had a point up until 2012 or so.

For much of the past year, however, the central bank has in fact tipped the scales in the opposite direction, preventing a depreciation even as the Chinese economy weakened and the dollar surged. In recent months especially, trading of the yuan has regularly swung towards the weak end of the 2% band, but the central bank has nudged it back up by orchestrating stronger midpoints. The reform the PBOC announced on August 11 sought to change this. From now on, the central bank declared, the midpoint would simply be the previous day’s closing value. Given that traders had been selling and buying yuan at a big discount to the manipulated midpoint, the new market-determined midpoint immediately fell by 1.9%, the biggest single-day drop in the yuan’s modern history.

That led to an even weaker market-determined midpoint on August 12, whereupon the yuan fell yet again, sparking fears that the currency might be on the brink of a rout. It was at this point that the central bank intervened. It ordered state-owned banks to sell dollars and buy yuan, propping up the exchange rate at the very time that it was being accused of devaluing it. This tug-of-war could play out for weeks, with traders repeatedly testing the limits of the PBOC’s tolerance for depreciation.

This raises the question of what the central bank is hoping to achieve. The most popular explanation is that it wants to stimulate its sluggish economy by cheapening its currency. The depreciation, after all, came just a couple of days after a surprisingly big drop in exports. However, the scale of the yuan’s weakening belies such a motive. The initial 2% devaluation only undid the previous ten days’ worth of appreciation in trade-weighted terms. The yuan remains more than 10% stronger against the currencies of China’s trading partners than it was a year ago. Much bigger falls would be needed to make a difference. But Chinese officials have forsworn a large one-off devaluation, believing it would undermine faith in the yuan and would do little to help the economy, since it would just persuade others to let their currencies weaken too.”

Depending on which analysis by which experts one listens to or reads, there seem to have been several different reasons for this generally unanticipated move on the part of the Chinese government. Some argued it was all about generating that sense of integrity and inevitability in the currency’s movements to support a push for the Chinese currency’s inclusion in the International Monetary Fund’s basket of special drawing rights. Such a result would earn it more leverage and prestige in international finance.

A second rationale might well have been to gain a bit of an advantage against other newer manufacturing competitors with still lower costs of production (especially wages) among Asian nations like Vietnam, Myanmar and Bangladesh – or still more productive economies such as South Korea. This would be especially true in the cutthroat export world of consumer goods as Chinese economic growth continues to slow from previously heroic rates of expansion. And a third and allied reason might also have been an interest in signalling to its domestic manufacturing sector that there is a growing need to increase international competitiveness through still greater efficiencies.

A further rationale might well be to take advantage of the decline in imported commodity prices (in dollar terms) to keep consumption costs relatively stable while increasing that competitive edge in exports through modestly lower prices.

Simultaneously, there was also the possibility that with the growing possibility that the US Federal Reserve was poised to raise its prime rate next month and thus increase the cost of borrowing for other nations, forcing other nations to match the rise in bond interest rates in the US. As a result, it has been argued by some that the Chinese government has been prepared to risk a currency war in order to gain a modest edge for its exports.

On the demand side for the Chinese and in understanding potential motives, as the Economist saw it: “The angst about the state of the world’s two biggest economies is understandable. China’s economy has slowed markedly: it is likely to grow by 7% this year, its most languid rate in a quarter-century. In addition, the government has been trying to reorient the economy from investment to consumption. For emerging markets that had been catering to China’s investment binge — those selling it coal and iron ore, copper and bauxite — the past few years have been little short of brutal. The economy’s slowing and rebalancing explain much of the 40% fall in commodity prices since their peak in 2011 and, by extension, the travails of countries which make their fortunes digging stuff out of the ground, from Peru to South Africa.”

Still, the Economist argued that China’s decision, while unexpected, is not likely to force that wild, unrestrained race to the exchange rates bottom. As that journal argued: “China can make itself felt in other ways, however. A slowdown in the world’s second-largest economy, for instance, is bound to have second-order effects on demand. Deflation in China puts pressure on firms in other emerging markets to cut prices. And some worry that the yuan’s fall may initiate a series of competitive devaluations, with other exporters racing to weaken their exchange rates or, perhaps, resorting to trade barriers as a last resort. Fortunately, the changes to China’s exchange-rate regime do not seem nearly big enough to set such a vicious cycle in motion. Even after its devaluation, the yuan remains stronger than it was a year ago in trade-weighted terms. Moreover, the authorities are now intervening to slow its decline. In other words, the depreciation is a small, belated step to keep the yuan’s value in line with those of its peers, not a dramatic shift in exchange-rate policy.” Still, other analysts warn that as soon as one nation triggers a decline in the value of its currency, it is not clear other nations will not respond more vigorously still, unwittingly setting off the very race this recent, modest Chinese devaluation was not aiming for in the first place.

In attempting to tease out motives, Peterson Institute for International Economics head Adam Posen argued: “There are two possible explanations: (The yuan is) becoming more market oriented so they’re in better position to be included in the SDR (special drawing rights currency basket of the International Monetary Fund) or, more likely, (the devaluation) is part of the panic set of attempts to keep the economy from declining faster. Somebody authorised the move and then the People’s Bank wanted to cast it as market liberalisation, and the bureaucrats compromised, which is why you ended up with this small move of 2%. If this is really about devaluation, 2% isn’t going to be enough to make any difference … They’ve eroded the credibility that the Chinese officials were going to stay out of the exchange rate or intervene against large movements. But, at the same time, it hasn’t moved enough to really help them. If you look at the history of exchange rate pegs, often what happens … is the first official move towards depreciation is too small because they’re scared to do it. And then once they do it, everyone starts worrying they are going to do more. This is particularly dangerous for China right now because the narrative starting last month, with all the huge interventions to try to stabilise the stock market, is that the Chinese economy is worse than we thought, the officials are panicking and we don’t know what they’re going to do next.”

The Economist adds that there is yet another complication in figuring out what happened in the conference rooms of Beijing’s monetary policy managers. “Some $250-billion of “hot money”, equivalent to roughly 2.5% of gross domestic product — an unprecedented amount — has left China over the past year as the economy has slowed. Strong inflows via the trade surplus have allowed the PBOC to absorb these losses so far, but it is wary of doing anything that might accelerate capital flight. A sustained devaluation would do just that, inviting speculators to short the yuan. Hence the central bank’s apparently contradictory actions, in letting the yuan fall and then trying to make it stop. As ever, China’s willingness to trust market forces extends only so far.”

Regardless of the precise, specific rationales and reasoning behind the Chinese decisions last week (and, importantly, there is no evidence this is the end of the currency movement), what are the likely consequences for other national economies? Here are some possible winners and losers.

While Chinese exports of manufactured goods could become cheaper, the actual cost of the product might well be offset if that manufacturer needs major amounts of imported raw materials that must be paid for in dollars or another hard currency. Still, lower prices in industries like clothing and basic toys (just in time for Santa Claus’s advance orders?) where international competition is already fierce and where producers in countries such as China don’t have much power to pass on their higher costs to shoppers would seem more than likely. But that presupposes that consumers in those countries are not also having to purchase things in their own devalued currency, of course.

Some market analysts have also been arguing that this (modest) devaluation could actually also give a boost to sales of inexpensive Chinese smartphones outside its borders. Chinese brands such as Xiaomi and Huawei already deliver competitively priced handsets with decent displays and performance. As the Chinese currency is weaker relative to others, this could make such phones even cheaper for consumers or allow Chinese makers to offer attractive discounts to would-be purchasers. Thinking more broadly, this devaluation may provide some Chinese companies with opportunities to push for bigger market share (rather than simply profits), thereby becoming a long-term threat to a company like South Korea’s Samsung, a market leader with high-quality equipment. Hi Investment & Securities analyst Song Eun-jeong told the media that in thinking about such a trend, Chinese budget handset makers might well enter developed country markets earlier than planned, especially if the yuan continues to fall.

Meanwhile, in China itself, imported foodstuffs like bananas are going to become a bit more of a luxury food item. As Stephen Antig, executive director of the Pilipino Banana Growers and Exporters Association, explained, the yuan’s devaluation will definitely have an impact on Chinese consumers and Southeast Asian banana growers. For example, the Philippines exports around 60-million to 70-million boxes of bananas a year to China, with an average price of $5-$10 per box. Antig says: “With the devaluation of the yuan, they have to pay more for every dollar that they buy and chances are some importers will reduce their purchases of bananas. But it will depend on how big the devaluation is because they are also buying bananas from Ecuador which are more expensive than what they are buying from us.”

Of course one unanticipated outcome of this devaluation may be to tamp down some Chinese tourist travel and their spending abroad, if they have to buy increasingly expensive hard currency with their increasingly devalued yuan. Specifically, Thailand, Malaysia Hong Kong and Taiwan may be most vulnerable to such trends, especially since they have become highly reliant on China’s demand for their exports and services – even as they compete with China in other export markets.

Credit Suisse analysts Santitarn Sathirathai and Michael Wan recently commented in a research note that Thailand’s loss of market share of hard disk drive production to China over recent years could accelerate further, if the currency trends continue. Thailand is also at risk because of its reliance on the growing tide of Chinese tourists, as some decide it is now too costly to take a foreign trip. Because travel and tourism is expected to account for about two-thirds of Thai economic growth in 2015, “a slowdown in Chinese tourist arrivals is the risk to watch”, say Sathirathai and Wan.

While the weaker yuan could be assumed to be beneficial to China’s exporters because their goods become more affordable for overseas buyers, there are yet other factors in the mix. With the yuan’s modest fall against the dollar this past week; the decline has not yet been large enough to overcome sluggish global demand and the increasing costs of production within China itself. Or as AP reported: “The long-term impact may be muted because yuan weakness adds pressure on Asian countries, for many of which China is their biggest trading partner, to devalue their own currencies to stay competitive. However, there’s little sign yet of a ‘currency war’ in the making, though some Asian currencies have already responded by weakening on their own, most notably the Malaysian ringgit.”

Meanwhile, in other big manufacturing economies in East Asia, South Korea and Japan, companies competing head-to-head with a Chinese rival may end up the biggest losers. In the steel industry, for example, both South Korean and Japanese producers are already bracing themselves to take a hit from the suddenly weaker yuan – especially given the global glut of steel production. As the AP said on this score: “With demand weak at home because of the slowing economy, Chinese steel makers are keen on increasing exports. Yuan weakness would push down the price of Chinese steel, intensifying the supply glut in the global steel market, and driving down prices globally, Mirae Asset Securities said in a report. And Kobe Steel official Tatsuro Kanno argued that this cheaper yuan could even help China ramp up steel exports to Japan. As Kanno explained: ‘There is concern that weaker yuan could affect the Japanese market in terms of imports from China’, adding that he worries that, ‘cheaper steel could come in (though) this is probably at least a month away, but it is a concern for the future.’ ”

And for South Africa? Well, if someone still has a job, Christmas toys and new clothing made in China (and perhaps elsewhere as those manufacturers recalibrate their costs downward to compete or their national governments go on a devaluation war) will become a tad cheaper, once the holiday shopping season begins in earnest. On the other hand, the local steel industry, already on the ropes, will feel the pain even more than at present since their costs – especially labour and energy –  cannot easily be squeezed further. With the higher cost of travel, this change in the yuan may also dampen the number of Chinese tourists to this country, at least those who can survive the gauntlet of South Africa’s new visa regimen.

Moreover, sadly, this change in the value of the yuan will not really help basic commodity exporters in South Africa because those payments are already largely calculated in dollars and their prices have been falling as global economic activity and demand remains in the doldrums. As a result, regardless of whether China’s decision was based on rational calculations of national interest, or stemmed from a desire to demonstrate more flexibility in exchange rate terms to qualify as a reserve currency, or from a sense of panic by Chinese monetary authorities, the results will not be beneficial to South Africa – or South Africans. Will any form of Brics solidarity help in these areas? That is a question South African government officials may want to focus on rather intently in the coming weeks and months. DM

Photo: A Chinese convenience store owner takes Chinese Yuan, or Renminbi, bills from his cash register in Beijing, China, 13 August 2015. China’s central bank on 13 August devalued the yuan for the third time in three days, to aid a slowing economy. The People’s Bank of China unexpectedly adjusted its daily reference exchange rate by a further 1.1 per cent, setting it at 6.4010 to the US dollar. EPA/ROLEX DELA PENA

For more, read:

  • China, the Fed and emerging markets Yuan thing after another at the Economist;
  • The devaluation of the yuan – The battle of midpoint China initiates market reforms of its currency, then backtracks at the Economist;
  • Peterson Perspectives Interviews on Current Issues Does China’s Currency Decline Portend an Economic Downturn? Nicholas R. Lardy says that economic indicators suggest that China’s growth rate remains stable at 7 percent despite the latest market pessimism at PIIE;
  • US economist sees yuan devaluation as panic by China at the Nikkei website;
  • China’s Latest Currency Actions Are Market Drive, a commentary by Nicholas Lardy at the PIIE website;
  • From bananas to phones: How cheaper yuan could reverberate at the AP;
  • Tea Leaf NationThis Map Shows the Global Impact of China’s Dramatic Currency Devaluation at Foreign Policy;
  • China goes all-in with currency devaluation at the Nikkei Asian Review.
Gallery

While we have your attention...

An increasingly rare commodity, quality independent journalism costs money - though not nearly as much as its absence.

Every article, every day, is our contribution to Defending Truth in South Africa. If you would like to join us on this mission, you could do much worse than support Daily Maverick's quest by becoming a Maverick Insider.

Click here to become a Maverick Insider and get a closer look at the Truth.


Newsflash

Zondo deals Lynne Brown a sucker punch: ‘Does she deny working with the Guptas?’

By Jessica Bezuidenhout

Towns near Fukushima are now being plagued by hordes of rampaging radioactive wild boars. Where are Asterix and Obelix when you need them?