Tuesday, August 11, 2015

China's currency move not a big deal

Perhaps it's because I'm on a beach in the middle of the Pacific, but I just can't get worked up about China's decision to relax its currency peg to the dollar, a move which has resulted—so far—in the yuan dropping by less than 2% against the dollar. It's hardly what you might call a "devaluation," or a "collapse," as some of the more breathless headlines read. It's more in the nature of an adjustment.

But first, let's put things in perspective.


The chart above shows the inflation-adjusted value of the dollar against two baskets of currencies: one, the "Broad" dollar basket, containing over 100 currencies, and the other containing a dozen or so major currencies. Since the early 1970s, the inflation adjusted value of the dollar has averaged almost exactly the same as its current value when measured against most of the planet's currencies. Relative to just major currencies, the dollar today is about 10% above its long-term average. So it's fair to say the dollar is somewhat "strong" relative to major currencies, while being simply "fair" relative to all currencies.


Over the past 20 years, China has strengthened its peg vis a vis the dollar considerably, from 8.4 yuan to the dollar to now 6.3. As the chart above shows, the real value of the yuan against all other currencies has doubled in the past 20 years. So it's fair to say the yuan has been an incredibly strong currency for the past two decades. That it should drop 2% against the dollar is hardly noteworthy. Maybe it was just too strong, and now it's a little bit less than "too strong."


The chart above is arguably the best way to appreciate what's going on with the yuan. With the central bank's decision to peg the yuan to the dollar (a peg which has been adjusted, mostly upwards, many times over the past two decades) comes the obligation to purchase any net inflow of foreign currency, and to be a seller of foreign currency in the event of net outflows. Even though the yuan has been getting stronger and stronger for years, China experienced an almost constant net inflow of foreign capital; the economy was booming and everyone wanted to get a piece of the action. China's foreign exchange reserves increased from almost nothing in 1995 to about $3.5 trillion today. But over the past year, China's forex reserves have dropped from $4 trillion to $3.5 trillion, which means China is now experiencing net outflows of capital.

As long as China's reserves were rising, it made sense for the central bank to allow the currency to appreciate. But now that reserves are falling, it makes sense to allow the currency to depreciate. Capital outflows are the world's way of saying that the yuan is "too strong." China is no longer booming, it's merely growing more rapidly than most other economies. The yuan will probably continue to fall against the dollar until it reaches a level that equilibrates capital inflows with outflows.  And there's nothing wrong with that. That's how currencies compensate for differences in the economic performance and relative attractiveness of economies.

The yuan is not suddenly collapsing or being devalued, it's simply adjusting to the new reality of slower Chinese growth.

A somewhat weaker yuan will make Chinese goods a bit cheaper for U.S. consumers, and there's nothing wrong with that either.

UPDATE: David Beckworth very nicely summarizes here the dilemma that China is facing with its currency peg. The thing to worry about is that it is going to be difficult for China to get itself out of the corner it has painted itself in. Trying to manage the yuan's peg is complicated by the rise of the dollar and China's desire to liberalize capital flows, all at a time when growth is slowing. If I'm being too optimistic about the central bank's ability to manage the peg without losing too much of its forex reserves, Beckworth lays out the bear case convincingly. I've been thinking the yuan has more downside, and he would agree; the problem I've perhaps underestimated is that the market is figuring this out and that is making the central bank's task more difficult.

19 comments:

Thinking Hard said...

PBOC devalued the yuan causing its biggest one day loss in 20 years. This will likely cause China to become net buyers of UST this year instead of being net sellers of UST YTD. The market was pushing for this by looking at net outflows YTD and the PBOC responded. This should also assist China’s export business. This may put a brighter spotlight on the Fed as the world watches for the first rate hike and the effects it has on the dollar.

Scott – Isn’t the PBOC setting the target range higher for the yuan by definition “devaluing” their currency?

Scott Grannis said...

China will be selling Treasuries until the yuan reaches a level that brings capital flows back into balance. The central bank will just have to play this by ear. The market by now has fully anticipated a slow and gradual rise in US rates, so there will only be an impact on the dollar if the Fed strays from its expected path.

I don’t consider a 2% currency decline to be a devaluation, but that’s just my opinion and my definition of a devaluation. A 5-10% downward adjustment to the yuan’s peg would probably qualify as a devaluation in my book.

sgt.red.blue.red said...

Why don't they just let the 'people's currency' float?

Scott Grannis said...

There's nothing necessarily wrong with a currency peg, and nothing necessarily superior about a free-floating currency. Both have their pros and cons. The latest move by China's central banks seems to be a mixture of a pegged and floating currency scheme. They will let the mark tell them if the peg should be changed. If capital flows are relatively neutral, then the peg won't change. If flows continue to be negative, the peg will be adjusted downwards.

Benjamin Cole said...

Q2 US unit labor costs rising!

At 0.5% annual rate...

The US Fed is courting a deflationary recessionary vortex...

William said...

Scott Grannis is probably correct in his overall conclusions since he is an experienced professional. I may well rue the day I went to 50% cash in October 2014. But I can't help noting that in Bear Markets economic and policy surprises are negative. In Bull Markets, it is the opposite: economic and policy surprises are positive.

Seems to me there have been quite a few negative surprises the past few months. Considering the $30 trillion of QE spent globally, there is not a hell of a lot to show for it other than avoiding a Global Depression - which is, of course, worth a lot.

Personally, my major about my position, is that the American Association of Individual Investors (AAII) poll data are only 24.3% Bullish, Bearish 31.7%, and 44% Neutral. With those numbers, I would prefer to be a raging Bull but I just can't be. The global economy is just too perverted for me.

Most markets rise on "Bad News" because investors believe that means their government and central banks will be more "accommodating" i. e. more QE and similar. That is what I mean by perverted.

Roy said...

"A somewhat weaker yuan will make Chinese goods a bit cheaper for U.S. consumers, and there's nothing wrong with that either."

And for Chinese households who are also net importers it will make things more expensive and thus will not assist with China's required adjustment of its economic model from investments to consumption.

Regarding "there's nothing wrong with that either", have you noticed the account surplus ruse in Europe? If everyone is pushing it on the US consumer, how come there's nothing wrong about that? You tend to blame everything on the local US [over ] regulation but the truth is that local regulation in countries outside the US have just as much impact, if not more, on local US economy and THAT's what's wrong with it.

"But over the past year, China's forex reserves have dropped from $4 trillion to $3.5 trillion, which means China is now experiencing net outflows of capital.

As long as China's reserves were rising, it made sense for the central bank to allow the currency to appreciate. But now that reserves are falling, it makes sense to allow the currency to depreciate."

1. And how exactly did they get to $4 trillion in FX reserves in they first place if they indeed let their currency appreciate as it should? Obviously they did not appreciate it enough when it was supposed to, so now all of a sudden it's a market-based correct move ignoring all the FX reserve base?

China is a developing country with no market economy in a crucial stage of its growth model. The US is nothing but. Context is everything.

Benjamin Cole said...

BTW, it is true that the yuan devaluation will be another deflationary shock in the U.S. China is the U.S.'s biggest trading partner.

This will be a "good" deflationary shock--but all the same, gives more room to the Fed to be expansionist, to take advantage of the devaluation to make our economy stronger.

China is a cipher right now. I suspect they will muddle through, as have all the Far East economies, although China's internal politico-economic repression is terrible, and perhaps will undermine their economy.

Scott Grannis said...

A 2% decline in the value of the yuan vis a vis the dollar is not going to produce a shock of any kind anywhere. In any event, the central bank of China is responding to an outflow of capital, which is probably directed to the dollar. Money is leaving China because it finds other currencies (most likely the dollar) more attractive. Lowering the yuan/dollar peg by a few percent is not going to change the fact that the world was no longer content to hold yuan at yesterday's exchange rate.

Scott Grannis said...

Roy: I think it's likely that the Chinese central bank was happy to accumulate forex reserves and to let the yuan slowly appreciate against the dollar for many years. China had every reason to want the yuan to both appear strong and to be strong (with a huge amount of forex in the bank with which to defend the yuan, should that have become necessary). But now the dynamic of capital flows has turned, and while it was Ok to lose $400 billion or so of reserves, losing more would not be a welcome development. Thus, the decision to allow the value of the yuan to decline modestly. Further modest declines might be necessary in order to stop the the outflows.

John McCormick said...

The "devaluation" is now 4% with trading in Asia on Wednesday. After a 10% drop in the Swiss currency brought down a couple of trading firms, I wonder what a 4% move in the Yuan can do?

IMF postpones China being included in the good ole boys club, so they say deal with this. Deflation is here, and it won't be tolerated, it can't be tolerated. QE4!

It is astonishing to me that the Fed has any credibility left. Talk about the boy who cried wolf. There is absolutely no way they can raise rates in September. They are trapped.

Dollar denominated debt has skyrocketed over the past few years in emerging markets. This will not end well. Raising rates, adding to the dollar's strength will only add fuel to the fire of a world economy that is walking on thin ice.

50% of S&P 500 revenues are outside of the US. Raising rates, adding to the dollar's strength will only add to the many footnotes in quarterly earnings reports... footnote 145 We would have made money except for the $2 billion we lost in foreign exchange.

GDP currently running around 1.5 - 2.0%, no signs of overheating here.
Productivity growth?
Labor force participation rate?
Government deficits?

Moral suasion only can carry the Fed for so long. I stopped believing them two years ago. There tools are all broke.

Food Stamps? 50MM people? make them go to the Government Food Bank and wait in line. I guarantee 80% wont show up. Just one small example of the changes I would love to see implemented.


steve said...

the fed will raise .25% in sept just to get off the dime. as scott as pointed out repeatedly, economic conditions in the US do not justify 0% interest rates. so to me the question is NOT whether they raise rates in sept but whether the follow through in '16. raising .25% IMPLIES follow through but I'm not at all convinced it will happen to any meaningful extent.

Thinking Hard said...

John – Yes, it is important to look at the devaluation in other currency terms besides the dollar. This has larger impacts in SE Asia. The dollars strength will pose significant problems in the EMs. Remember, QE4 is not necessary, we only have to get the reserves flowing out of the Fed and into the economy in order to ease monetary conditions. There are plenty of reserves (approx. $2.5T) to get things flowing.

There are demographic and policy (student loans and health insurance) issues underlying the labor force participation rate. Productivity growth is running lower than normal. Good article in today’s WSJ on this. Government deficits are not really a concern and under current economic theory should actually be higher. I don’t condone higher government debt and deficits, but current utilized theory says it’s fine.

The tools of the Fed are not broken, it is a matter of using the tools while maintaining confidence. I still see no reason to begin raising rates and actually prefer looser monetary policy because I don’t see building inflationary pressure. The only reason to raise rates is to maintain confidence, although I don't see a lack of confidence and faith in the Fed or the dollar right now.

Roy said...

Scott,

It's obvious what they are trying to do. They are are either clueless or unable to do what they should due to political reasons. The outflows will only get stronger. It's unclear how you got to your conclusion. Again, China is not the USA.

Thinking Hard said...

Roy - It is highly likely China will have to devalue even further to find equity price support and economic growth support. They are struggling to maintain high growth rates, and the markets/economy are not ready for decreased growth prospects, although that is exactly what needs to occur. Further devaluation will ease the outflow until they reach an equilibrium point. What effect does that have on the US and the monetary policy coming out of the Fed?

I see a disinflationary impact from a stronger dollar and weaker yuan. I also see a lot of potential volatility in the UST market because there are a lot of unknowns right now. Political fallout is not something I see, but will become an important factor to consider moving forward.

China may also be throwing a wrench into the TPP by showing SE Asian nations currency alterations are necessary at times. Perfect timing to disrupt a potential US monetary power grab at their doorstep.

Matthew Grech said...

I'd like to float an idea... (I'm in the camp that says there's no good reason to boost the Fed Funds rate except for the vague notion that it gets us closer to "normal." So many things tell us that inflation is not a problem that I just can't believe the Fed is contemplating a rate increase but I acknowledge I'm in the minority.)

The Fed could boost the Fed Funds rate while at the same time reducing the rate - perhaps by one basis at a time - it pays on excess reserves. In this way, all the people who would like to see us get closer to "normal" on a Fed Funds basis would be placated. And all those people who (rightly) worry about the Fed not providing adequate liquidity would also be placated. And the beauty is that this reduction in IOER could be characterized as getting closer to normal as well since it would be true.

Thinking Hard said...

How much in UST terms will China need to sell in order to drop the yuan peg 2%? 5%? 10%?

Scott - What implications do you see in the UST and USD markets?

Matt - I am in favor of a reduction in IOER and allowing some reserves to flow into the economy. I don't see that option in any Fed policy discussions at this time.

Scott Grannis said...

Some currency context: The Euro fell almost 25% from mid-2014 through March of this year, yet it did not spark any disastrous consequences. The yen has fallen a mere 4% so far.

There is an important difference between the two currencies however. The Euro is free-floating, but the yuan is a managed peg. When the Euro falls vis a vis the dollar, it is because the dollar became more attractive relatively speaking and market forces were at work. But when the yuan peg is dropped via the dollar, it is the result of a decision by China's central bank.

In a managed float, like China has, net inflows of currency must be purchased by the central bank, and that results in an expansion of the Chinese monetary base and its money supply. Dollars flowing into the country are converted to yuan. When there are net outflows, as there have been over the past year, the central bank must sell dollars (e.g., by selling its Treasury holdings). That results in a shrinkage of the monetary base and a shrinkage in the Chinese money supply. Yuan leaving the country are converted to dollars.

If the central bank manages to lower the peg to the "right" level (the level at which there are no net inflows or outflows) it would not have to buy or sell anything. Sooner or later, lowering the yuan's peg will do that, and the central bank will cease selling Treasuries. In the meantime, the Chinese money supply will shrink, and that will help restore equilibrium, just as share repurchases tend to bolster the value of a stock.

This process needn't be disruptive, although of course it is possible that the central bank could fail to properly implement a managed peg (e.g., by not allowing capital outflows to shrink the money supply).

NormanB said...

"A somewhat weaker yuan will make Chinese goods a bit cheaper for U.S. consumers, and there's nothing wrong with that either."

This also makes goods more expensive for the Chinese consumer which belies their government's call for a stronger consumer oriented economy. A $750 sofa from IKEA in Palo Alto costs $1,250 in Beijing.