What can the Chinese devaluation bring?

Good morning!

Yesterday morning Chinese authorities made yet another move aimed at supporting the Asian economy which seems to have succumbed to speculations that a slowdown is long overdue. After weak trade data, a slump in equity markets (which nevertheless continue to post healthy year-on-year gains), a worse than expected plunge in producer price index and other below-expectations statistics, the Popular Bank of China (PBoC) announced that it will devalue the currency by 2% and that it will change the exchange rate determination method. The new methodology, which is deemed somewhat more transparent and market-driven, should lead to a weakening in the Chinese yuan (CNY).

The first consequence of this decision that comes to mind is that of improved competitiveness for Chinese exporters which naturally is due to diminish the gains accrued by other regions which have seen their currencies weaken. It will hence reduce the advantages brought about by a falling EUR to the European corporates and raise concerns about currency wars and policy predictability.

Overall, this move increases the likelihood of a pickup in Chinese export volumes and, for their importers, it is akin to importing deflation since these goods will be bought at lower prices. It goes without saying that this would exacerbate lowflation worries as it comes after renewed weakness in oil and sub-optimal long term inflation expectations (particularly in the Euroarea).

A devaluation of the CNY also means that the Asian giant is acknowledging that its effort to shift from an exports-based economy towards a service one has hit a hurdle. This in turn sends a bearish message particularly as worries abound that the pick-up in trade will not be easy coming and that it is in part explained by the subdued investments worldwide. Hence, it is perhaps not surprising that markets were not too buoyant at the news of the new step taken by PBoC.

On the other hand, a weaker CNY makes imported goods more expensive for Chinese which could hit sentiment in the durable goods sector. For this scenario to be adverted, consumer sentiment and, by extension, demand, would need to be boosted by a rebound in exports-leveraged sectors; however, as explained earlier this might well not be the case.

To conclude, I think the recent decision is broadly bearish for commodities and other sectors exposed to the Asian economy. Similarly, the country’s largest trading partners will likely take a hit. By contrast, it should be good news for the core Euroarea yields as inflation expectations are unlikely to recover in this environment. In the equity market, the move can foster persistent volatility while the emerging trend will likely reflect the perceived monetary policy implications (i.e. ECB challenged to show further commitment towards intervening as necessary and Fed unlikely to make any strong moves).

Have a nice day!

Raluca