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China Currency Shock Fuels Sell-off

Although the yuan's decline has been small so far, fears that it will depreciate further have fuelled a global sell-off, says Morningstar’s Bob Johnson

Robert Johnson, CFA 14 August, 2015 | 8:00AM
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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. China's surprise move to devalue its currency has sent a shockwave through global markets. I'm here with Bob Johnson, he is our Director of Economic Analysis, to see exactly what China did and why investors are so worried about it.

Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: Let's talk about this move on Tuesday and then again on Wednesday China made some moves at this currency. What's happening?

Johnson: Yeah. Basically, on Tuesday they decided to let their currency devalue by about 1.8% and they went ahead and did that. Then on Wednesday the currency even fell more than they kind of officially brought it down.

So then they intervened in the marketplace from keeping it from falling anymore. So they kind of one day intervened and tried to bring their currency down, then it came down more than they thought on the second day and so they kind of reacted at the very last minute, the last 15 minutes of the day and kind of propped things up.

Again, the devaluation was about 1.8%. We got pretty close to a 4% decline at one point on Wednesday and they brought it down to about a 2.8% decline by the end of Wednesday, that is, compared to Monday's closing price.

Glaser: Can you give us a sense of how big of a move this is the currency compared to historical trends?

Johnson: Well, you know what, since 2005 they've really kind of strengthened the Chinese currency and we've had a fairly good move. I mean, instead of costing 8 of their currency for $1 it got down to the low 6. So, we've had a pretty big move. Now, we've kind of moved up a couple of tenths from 6.25 or so at the low to 6.38 or something like that. So, compared to where we've been over the last 10 years, this is a tiny move, so far.

Glaser: So, why would they do this then?

Johnson: I think there were two parts of this. One is, initially, especially on Tuesday their thought was, well, let's – we've seen the currency work that kind of has ways of trading out of China all look a little bit weaker.

We understand our economy is a little weaker, we're going to acknowledge this and let our economy do what the market is saying and let it float down and look at we're great market guys, which was a great theory and then they kind of blew it on Wednesday by intervening when it got down almost 4%. Then it's like, well, we really want to be in the driver's seat here.

So that might have kind of conflicted with what they did Tuesday a little bit. But nevertheless, it is a move down and it's a recognition that their economy is a little weaker than they would like to be and they like to stimulate their economy and their economic growth as well which is what a currency does and makes it more competitive in overseas markets and allows them to export more and of course, their export economy has been in tough shape the last few months, kind of surprisingly tough shape.

Glaser: You said in the broader context this isn’t a huge move. It's not a big secret that the Chinese economy is somewhat weak. Why are markets selling so much off on this move then, what's the big fear?

Johnson: Well the fear is that they actually stepped in to force devaluation and then there is some fear like, okay, now they've shown a willingness to do this. How much more is behind it, couple of tens of percent isn’t a big deal in terms of or couple of ticks on it isn’t a big deal. It's a thought that well they have started this but the economy doesn’t get any better they are going to do this again and again and again, and where do we end up.

Most of the other currencies and those interest rates trading in such a way you can kind of see a pattern where people are anticipating that there are more devaluations behind this one. So I mentioned this one is relatively small I mean we've moved over half a move on just this year and now we are back just a little bit of that. Just in the last year so it's really not a market moving type of thing. But the problem is how many more are behind this. I mean certainly some of the economic data out of China's day was just a little bit soft looking I mentioned exports have been soft forever, so those are all things weighing on them?

Glaser: What will the impact of further devaluation be on the global markets?

Johnson: Certainly, it's not great news for the rest of the world economy. It means that the China is trying to be more competitive and it's going to be harder and harder to compete against them in foreign markets if they keep devaluating the currency.

I think the current move probably isn't enough to move the needle, but if indeed, we end up with the 10% drop in the Chinese currency relative to the dollar, that might make a big deal and that will displays who's the big leader in trade. So that's certainly something that most people are worried about is what's that long-term knock-on effect.

Then the other things that's got people worried is certainly we're trying to get inflation up a little bit around the world, so that Fed policy and other central bank policies can operate, and this certainly can – throws a deflationary move at the marketplace, so that's certainly not a good thing because prices from Chinese goods will come down in other currencies, so certainly that's going to put a little bit more deflation pressure which is kind of the last thing we all need right now.

Glaser: Who potentially is the most exposed to this?

Johnson: Well, that would for sure be other emerging markets and very commodity-oriented economies. Clearly, the Australias and the Brazils of the world, are suffering, even Canada I just saw report today suggesting that their people believe that their first half – they are very close to being in no growth in Canada.

And some of that certainly is related to commodities and oil which is all kind of wrapped up in a slow Chinese economy. And that's just shows you how big the knock-on effects are. And Russia too, a lot of emerging markets are going to be very hurt and we said time again everybody says,well, China is weak, oh, it's bad for the U.S., no it's not bad for the U.S. – it's 1% of our GDP and a lot of the jetliners that have contracts that just go on forever anyway.

So I am not worried about the U.S., maybe Europe I worry a little more because Germany in particular sells a lot of capital goods into China, and so certainly, it's not a good thing for their economy.

It again probably no disaster, but commodities-focused economies like Australia, Brazil, the oil industry are all are going to be hurt by this, and in general, other emerging markets that are trading partners who will be hurt as well.

Glaser: There is some commentary that this move may will give Fed an excuse not to raise rates in September, do you think anything like this will have an impact on that decision in just couple of weeks now?

Johnson: My usual generic answer will be probably not, but clearly, the rest of the world disagrees with me. There are people that show probabilities of what economists are thinking the rates will be and when the rates go up and maybe it was 50-50 round numbers a couple days ago, and now it's kind of all 40% chance in September, 60% sometime later.

So clearly, everybody thinks it may delay them, and certainly, the primary mechanism where you could think it make a difference is it slows world inflation, and that's certainly one of the things that they are trying and get up and that's one the two targets they said has to be higher as does employment in the U.S. and so we'll get the employment part later, but for now it looks like, yeah, maybe it will put a brake on inflation and that might limit the Fed's options. So yeah, it could delay them.

Glaser: Bob, thanks so much for your analysis today.

Johnson: Thank you.

Glaser: For Morningstar, I am Jeremey Glaser. Thanks for watching.

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Robert Johnson, CFA  is director of economic analysis with Morningstar.