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What’s Going on With the Yuan?

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Following a dramatic escalation in trade tensions between the U.S. and China early last week, the Chinese yuan depreciated significantly against the U.S. dollar, as seen in the chart below. For many, both investors and political pundits, this devaluation seemed a clear act of currency manipulation by the Chinese regime – in fact, the U.S. Treasury department designated China as a currency manipulator in the immediate aftermath. But given frightening headlines, equity market turmoil and a general shock to confidence, investors may benefit from understanding in greater detail not only what exactly has happened with the Yuan, but also how it matters.

As a point of semantics, it is first worth pointing out that while the recent currency devaluation was indeed a deliberate, encouraged act, it was not in true form an act of manipulation – at least not in the direction of undue depreciation. After all, the Chinese government has been allowing the Chinese Yuan to trade more in line with market forces, which were actually pushing for a weaker currency than what was ultimately permitted by the People’s Bank of China this week. Perhaps ironically, then, currency manipulation is occurring to strengthen the Yuan more than to depreciate it.

But semantics aside, the implications of the currency depreciation are nuanced; indeed, it is a double-edged sword for the Chinese economy. On one hand, it helps to offset some of the negative impact from tariffs and thereby counter the decline in the current account surplus, as a weaker currency makes domestic goods cheaper for foreign buyers. On the other hand, a weakening yuan also raises import costs and deters capital inflows, which would be counter-productive to China’s long term goal of market liberalization. Lastly, it might encourage capital outflows, as Chinese companies and investors look to send money abroad before further depreciation.

All told, investors should remain calm in the face of this particular development. While Asia’s trade cycle will likely remain under pressure so long as trade tensions persist, domestic demand in China and Southeast Asia are still supported through structural forces. Moreover, Asian central banks are now looking set to ease interest rate policy, a positive for Asian fixed income, especially in the sovereign space. Short term focus will remain on currency risks, and as usual all eyes will look to Chinese-U.S. relations. But with the global search for yield only becoming more desperate and demographics counting to remain appealing, investor interest in the region should remain, regardless of currency weakness.

Related: Why Are Markets Down So Far in August?

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