The Renminbi, the Global Economy and the Fed

In the immortal but clichéd words of Herbert Stein, “If something cannot go on forever, it will stop.”

So it did. After building an aura of invincibility over the last decade, China’s policymakers finally devalued the renminbi. While the magnitude of devaluation was very modest (1.9%)—and technically within range of the original peg—the devaluation act itself is a monumental step, in my view.

China’s currency devaluation was inevitable

China’s de facto currency peg to a strong dollar created an untenable situation. The slowing Chinese economy needed help to transition to a more consumer-focused economy through monetary-policy support. Unfortunately, the peg effectively tightened monetary conditions at the worst possible time and has so far taken a heavy toll on the Chinese economy.

In typical fashion, China has devalued partially but continues to maintain the stoic appearance that it maintains a grip on policy and future devaluations. China’s policymakers would like us to believe that this is a one-off event. Regrettably, that’s not how things are likely going to work out.

By building expectations that it would maintain the peg and then back off from that policy later, China only encourages capital outflows even further. These outflows are what led to tightening monetary conditions in the first place. Now, to prevent future outflows, China will need to intervene even more heavily in domestic markets through even tighter monetary policy. This vicious cycle will go on as Chinese policymakers inflict even more pain on their economy—until they relent again.

Much as China would like us to think this devaluation will not occur regularly, I firmly believe that it’s the first in a series of devaluations to come. There’s just no way around it.

What does all this mean?

China’s gain is the world’s loss

From a cyclical standpoint, this and future devaluations may actually be positive factors for economic growth in China and, to some extent, in few other emerging markets—and here’s why.

Currently, China and emerging market countries are the biggest detractors at the margin from the trend rate of global economic growth. But currency devaluation should help in the medium term: If “bottom fishers” seeking discounted assets arrive on the scene to capitalize on a positive economic outlook, they would help stabilize asset prices in emerging markets and marginally support commodity prices (albeit with a lag) as well.

However, in the same vein, the outlook for developed markets suddenly got a lot worse. Effectively, China’s devaluation unleashes to the world the next round of global disinflation that policymakers in developed markets have been working so hard to climb out of. While developed markets continue to do well from a cyclical perspective, the specter of imported disinflation is extraordinarily problematic from a secular standpoint. If wages can’t grow much, the world’s trend growth rate may get fully stuck at 2%.

China’s devaluation mounts an acute policy challenge for the U.S. Federal Reserve, which has given every indication that it wants to tighten policy soon. If the Fed indeed raises interest rates, make no mistake: The ensuing strength of the dollar will effectively stunt the current growth spurt in the United States, notwithstanding its low unemployment rate, and we might be talking about a fourth round of quantitative easing—or QE 4—in the not-too-distant future.

The implication for asset prices and global interest rates

The bottom line? China has devalued its currency—and needs to devalue even more. After a bit of a lag, in which its economy will be squeezed further, I predict that China will proceed with additional rounds of devaluation, which would be a step in the right direction. Unfortunately, the outlook for the rest of the world as a result isn’t so sanguine. China’s devaluation will reinforce a global disinflationary trend. If you’re a bond investor and worried about rising rates, China’s devaluation—and the disinflationary pressures that would result—should mollify your concern a lot.

If the Fed goes ahead with its rate increase as I expect, it risks making a policy error that would have negative implications for U.S. asset prices in the near term until it eases monetary policy once again. I hope I am wrong on that front. Either way, I am left once again to reiterate my long-held view that interest rates are going to remain low on a global basis for quite some time.

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