Stock markets around the world are cratering barely a week into 2016 and it seems like we are back in August of 2015 when the last correction took place. Once again, China stands tall amongst macro drivers, along with plunging oil prices.
Last Wednesday China’s equity market closed early, down 7%, with trading halted within thirty minutes of the session opening as brand new circuit breaker rules (instituted in 2016) were triggered. This follows a similar halt on Monday. Chinese authorities are clearly scrambling, with their stock market regulator announcing on Thursday that it would be s uspending the circuit breaker rule , for now.
So what’s going on?
It mostly comes down to understanding what is happening with the Chinese yuan and credibility questions about Beijing and the People’s Bank of China (PboC). Chinese equity markets opened lower today after the PboC announced the yuan reference rate at a five-year low.
But some history may be helpful first.
Moving to a managed floating rate system
The yuan was pegged to the US Dollar (at 8.28 yuan per USD) until July 2005 when the peg was lifted and revalued to 8.11 per USD, strengthening the currency by about 2%. The idea was to make trade in the currency simpler and efficient as China went from a fixed exchange rate system to a managedfloating rate system. The currency was allowed to float within a 1% band about the PboC’s peg to a basket of currencies. The bank however ignored the previous day’s trading when setting the midpoint fix (to the USD) for the next day.
The currency appreciated 21% to 6.83 per USD over the next three years. In August 2008 the global financial crisis prompted the PBoC to repeg the yuan to the USD and halt its appreciation as global demand waned.
China removed the dollar peg in June 2010 and the currency once again appreciated about 11% by the end of 2013 to about 6.05. Now even after all the appreciation between 2005 and 2013, the general consensus seemed to be that the currency was significantly undervalued, with US critics in particular accusing China of controlling its currency to give its companies an unfair advantage . Since the yuan would appreciate significantly against the dollar if allowed to float freely, China capped its rise by buying dollars and selling yuan – resulting in vast foreign reserves that peaked at $3.9 trillion in June 2014.
A slowing global economy
Over the past few years the US economy has strengthened while the rest of the world’s economies, including China, seem to have stalled. As a result the dollar has appreciated, not least because central banks in Japan and Europe embarked on implicit policies to devalue their respective currencies and boost exports. As an export-dependent economy, China could potentially join this “currency war” by simply relinquishing some control over its currency and letting the market devalue it. Of course, in theory China’s vast amount of reserves would allow it to step in at any point and prevent the yuan from falling too much.
In March 2014 the PBoC widened the yuan trading band around the daily fix to 2% (from 1%), allowing the currency to move up to 4% a day. By December 2014 the yuan spot price moved into the weak end of the trading band as markets tried to force the currency lower.
Meanwhile Chinese economic data continued to show a slowdown, with exports shrinking 9.5% on the year in July 2015.
Currency reform or competitive devaluation?
On Thursday, August 11th 2015, China surprised global markets with a 1.86% devaluation in the yuan’s midpoint fix, their biggest such move since 1994. At the same time, an equally important announcement was a move to set the midpoint fix to reflect the previous day’s close, thus making the yuan dependent on daily trading.
Ostensibly, China’s goal was to allow market forces to have a greater role in its currency as a step toward making the yuan a global reserve currency. The IMF called it a “welcome step” even as it believed the currency to be no longer overvalued and was considering including it in its SDR basket (Special Drawing Rights). On November 30, the IMF agreed to add the Chinese yuan to its SDR basket in October 2016, citing the yuan’s role as “ freely usable currency ” .
On December 11 the PBoC again caught the world off guard, announcing that the yuan’s exchange rate will no longer be fixed to the USD, but instead to a basket of currencies that included the yen, euro, British pound but also the Russian rube, Thai baht, Malysian ringgit. As Nash and Wray discussed at the time, on the face of it the move looked like reasonable reform toward a more open capital account. However in practice the decision to depeg from the dollar could be interpreted as a move towards supporting a slowing economy and perhaps even regaining lost ground.
On January 6th 2016, the PBoC fixed the yuan to a fresh five year low at 6.53. The currency has fallen 6% against the dollar since July.
Without going into too much detail and adding to an already long post, I will point out that there is an “offshore” yuan as well, which is allowed to trade freely in Hong Kong. The offshore yuan typically trades at a discount to the onshore yuan and is also at its lowest level in five years, while the spread between the two versions is at a record level. The PBoC’s inability to narrow the spread, which it pledged to do last August as part of its goal to make the currency freely usable, raises concerns over their credibility.
Exporting deflation
Irrespective of China’s motivations, the depreciating yuan could increase global currency tensions as China’s ailing companies strive to become more competitive at the expense of rivals in Europe and Asia. Note that China is still the world’s largest net exporter and is more dependent on the world than the other way around.
There are reports that the PBoC is under increasing pressure from policy makers to let the yuan fall quickly and sharply, by as much as 10-15%, as its recent gradual softening is thought to be doing more harm than good. The bank’s intervention has come at a cost. The PboC is spending billions of dollars of reserves to support a yuan under pressure even as economic growth is decelerating and capital flows reverse, with ordinary Chinese and businesses rushing to change yuan into dollars. FX reserves dropped by a record $107.9 billion in December and have fallen in every month but one since May as the next chart shows. Reserves have dropped 15% since June 2014, falling more than half a trillion dollars to $3.33 trillion in December.
At first blush, it would seem that China has enough reserves to still maintain control over its currency. Nevertheless, as with any savings account, it gives you confidence until you start drawing it down.
The question no longer seems to be whether China is slowing – it is – but whether authorities can manage a “soft landing”? Till the past year, the answer seemed to be in the affirmative but confidence seems to be waning. Is China biting off more than it can chew, between managing its currency and starting global projects like the Asian Infrastructure Bank and the Belt and Road initiative ? All this in addition to the biggest task of them all: transitioning the economy from an export-based one to consumption-driven one.
The other question is whether China’s actions will unleash a wave of deflation across the world, even as the Federal Reserve appears to have embarked on a tightening path (expecting inflation to rise back to target).
Risks from an imbalanced global economy
In the short-term, it remains to be seen how the various economies, and central banks, of the world fight deflationary pressures and stoke higher inflation. Or do they fall back on the American consumer as the last resort? This would not be an ideal situation for anyone.
In the years prior to the financial crisis, the rest of the world saved and bought American debt as consumers in the U.S. shopped, leading to huge imbalances in the global economy – the fact that some countries had large trade surpluses (exports larger than imports) and others (like the U.S.) with large trade deficits. In the years after the crisis, the hope was, or is, that countries (like China) that rely mostly on exports would transition to a consumption-driven economy. However, with the rest of the world’s economies remaining in stall speed and the U.S. dollar strengthening, American exports will continue to suffer even as another consumption binge looms, forestalling a more balanced global economy.
It would be ideal, even for the U.S. economy, if the rest of the developed world could reflate their economies while China and other emerging markets successfully manage to transition toward a consumption driven economies.
If not, the question becomes as to how long the U.S. can remain as an island of stability . Risks become enormous particularly if external headwinds creep onto U.S. shores and causes the economy to stall. The Federal Reserve does not too many tools left (other than QE and/or negative rates?). More crucially, the current political environment makes fiscal support less likely.
In a sense, the main macro story from 2015 continues into 2016 and we continue to monitor events carefully to see what the rest of the year will bring.