China Isn't Starting a Currency War

China surprised the world on Tuesday by allowing a 1.9% fall in the value of the renminbi against the US dollar. While the People’s Bank of China (PBOC) sets the renminbi’s daily fixing rate each day, and allows that exchange rate to float within a 2% band, the size of the inter-day fall is surprising. On Wednesday and Thursday, the PBOC continued to tie the forex midpoint rate to the previous day’s closing rate, signaling further currency devaluation and raising concerns over China’s policy goals.

“One-time” correction

The PBOC has characterized this devaluation as a “one-time” correction. Taking them at their word, this sends a signal to financial markets that continued devaluation may be acceptable but will only occur at a slow rate within the tight band allowed. On Wednesday afternoon, the PBOC advised commercial banks to sell USD dollars as an attempt to prop up the renminbi value, which further proved China’s intention to maintain a controlled weakening of the yuan. We do not expect steep additional devaluation or intense volatility in the USDRMB exchange rate, but companies should be prepared for a trend towards devaluation.

China appears to have two main goals in allowing its currency to weaken.

Improve sagging exports: A currency devaluation could help to support an economy that is slowing at a faster rate than the government would like. This slowdown is showing up in statistics that the government cannot avoid, such as a recent reading of an 8% contraction in exports year-to-date. A cheaper renminbi makes China-made goods relatively less expensive for global consumers.
Liberalize foreign exchange transactions: China is seeking a greater role for the renminbi in global currency markets, in particular by being considered for the IMF’s Special Drawing Rights (or SDR) basket, which would signal its use as a global reserve currency. The IMF’s delay in such a decision last week allows the Chinese government to boost exports while also pointing to liberalization of the currency in line with IMF expectations.
Concerns of currency war are overblown

China’s action in currency markets is a rescue mission to prop up exports, not an attempt to start a currency war. In fact, the devaluation is likely to tell us more about the government’s discomfort with its political and economic reality than about currency itself.

In addition, the size of the currency movement itself is very small relative to foreign exchange markets globally over the past year. Global currencies have depreciated 10-30% relative to the US dollar so far this year, while the renminbi has appreciated by 14% against a basket of its trading partners’ currencies. The renminbi’s current devaluation is thus relatively small, yielding only marginal improvement in export competitiveness. Meanwhile, emerging markets globally have found production inputs more expensive as their currencies depreciate. China’s marginal export boost is unlikely to outweigh global economic trends in determining its trading partners’ monetary strategies.

Impact to China’s economy

The PBOC’s devaluation of the renminbi can best be understood as a short term action to support the government’s long term goal. Growth is slowing more quickly than the government would like. Growth levers such as investment (slowing), consumption (weak), and the stock market (experiencing a crash) have been diminishing in their effectiveness. Using currency markets as a lever for boosting exports enables the government to back into a GDP figure for 2015 that is politically acceptable.

While we do not expect a substantial improvement in the export environment in China as a result of this relatively limited activity, the currency devaluation could provide just enough of a floor to keep the economy within the government’s expectations. Taking all this into account and given the reduced levels of consumer and investor confidence resulting from China’s stock market volatility, we have revised our expectations for China’s 2015 GDP expansion from 7% to 6.9%, along with lower consumption and investment forecasts. The currency devaluation impact on China’s trade expansion is unlikely to be huge, and we expect the Chinese government to undertake more stimulus actions to boost export growth in 2015.

Impacts to foreign companies doing business in China

A cheaper RMB does result in some incremental profits for purchases made of Chinese goods. However, since most global currencies have depreciated by much more than the renminbi’s recent movements, much additional activity will be on the margin. In the meantime it is worthwhile to evaluate your Chinese customers and channel distributors on their foreign-currency debt levels, as local governments and property developers will be facing increased burdens of repaying dollar-denominated debt.

Impacts to global business

Increased currency volatility: If China continues with a more aggressive currency devaluation, some direct export rivals in the APAC region could follow suit to maintain their export competitiveness. However, we expect a much more intensive bout of currency volatility as a result of the US Federal Reserve’s interest rate hike, likely to take place later this year.
Intensified competition from Chinese exporters: Even moderate improvements in price competitiveness for Chinese exporters create opportunities to grow their market share, and could encourage them to compete more proactively with foreign rivals in your India and ASEAN markets. While we do not consider rapid, sustained devaluation as the base case for the renminbi, executives in APAC and globally should consider the impacts of a Chinese slowdown to their business.
Increased likelihood of China downside: While the stock market crash and currency devaluation are not conclusive signs of financial market crash, they are signposts of the “Chinese Financial Crisis” downside scenario that FSG has been monitoring since late 2013. Executives should engage in scenario planning on account of the higher likelihood of this downside scenario.