In a surprising move, the People’s Bank of China (PBOC) cut its currency by 1.86% (call it 2%) overnight yesterday. The first day, global markets reacted with what can only be described as panic, spanning stock markets, bond markets, currency, and commodity markets alike. Investors flocked out of the U.S. stock market (Nasdaq down 1.5%, Dow down 1.35%) and into the U.S. Treasury or bond market, oil crude futures fell by almost 4%, and the Aussie dollar and Canadian dollar fell over 1.65% and .9%, respectively.
“Pish, posh,” you say, “two percent is a pittance.” You probably didn’t say that, but compared to other currencies’ value change against the US dollar this year, it certainly is: the euro is down 9.5%, AUD has fallen almost 11%, and the CAD has shed almost 13%. While the USD has gained in value against all other major currencies this year, the USD/CHY exchange rate (US dollar for Chinese yuan) has stayed almost entirely unchanged. This is because the PBOC manipulates the rates, keeping them at a constant valuation compared to the USD since 2005.
The question that immediately comes to mind is “Why has this less than 2% devaluation of a currency caused such shockwaves across all fiscal markets? The answer lies in two parts: What the 2% devaluation does mean, and what the 2% devaluation could mean.
Allowing the yuan to devalue 2% made every import 2% more expensive for those holding the Chinese currency. China is a huge importer, as it’s an emerging market (an economy that is still growing at a substantial rate). To put it into numbers, oil will cost China $345 million more per day just from the first devaluation. Conversely, this devaluation will encourage exports, as business overseas is now 2% cheaper. Encouraging exports boosts manufacturing of those items that can be exported, so currency devaluation buoys up manufacturing, which is good for an economy.
The manufacturing output of China has been a concern; the manufacturing PMI, which tracks the overall manufacturing sector’s growth compared to the previous month, was at 50 for July. This is a neutral rating, and a neutral rating is a very bad rating when it refers to a country that accounts for 18% of the world’s manufacturing. This is a big reason why the markets reacted so strongly to the devaluation: if China is in such dire straits that it is devaluing its currency, the straits must really be dire. Demand from China is a big driver for every market. Big corporations listed on the New York Stock Exchange have been earning a larger and larger percentage of earnings from China, about 9.3% of world oil consumption takes place in China, and 12.4% of global GDP comes from China. Basically, what happens in China affects all markets.
What the weakening of the yuan does mean is worrisome; what it could mean is downright frightening. If the People’s Bank of China is so worried about manufacturing that they are allowing their currency to devalue, it could be just the start. A 2% valuation cut wasn’t going to be enough to move the behemoth that is the manufacturing of China. Further cuts will be needed, as evidenced this morning by another devaluation. Not only will these further cuts cause the US stock markets and global commodity markets to fall, further weakening might break the peg to the USD. If this happens, China, which is one of the biggest buyers of U.S. Treasury bonds, will no longer buy. So not only will commodities and stock markets be hurt, but the USD could weaken considerably if further currency market intervention by the PBOC is deemed necessary.
Again, what does this mean to us? Yesterday the PBOC tried to encourage markets by calling it a one-time occasion. As the PBOC wasted no time in devaluing the currency another 1.6% today, that statement was clearly misleading, and further cuts are more than likely, no matter what China says. This past year, the US dollar has strengthened considerably as oil has plunged and uncertainties abounded in Greece. The reign of “King Dollar” may be cut short indeed if its biggest bond-buyer becomes its biggest bond-seller. The somewhat sleepy currency markets are coming roaring back, and it will likely be at the greenback’s expense.