August 14, 2015
With a lack of compelling headlines coming from Greek debt negotiations and no exciting news out of the U.S. Federal Reserve, it looked like this week would be another summer snoozer. Fortunately for the financial soap opera fans out there, China came through and delivered the drama. On Tuesday, China surprised the world by devaluing their currency (the renminbi/yuan). The move caused ripples in markets across the world as many feared it was a sign that the Chinese economy was in much worse shape than previously believed.
So what is all the hoopla about? Why has Donald Trump been complaining about China for years? What makes China's currency so different than other common currencies? High level explanation coming up...
The Chinese yuan is not freely traded. Instead of supply and demand determining its value, China's central bank sets the valuation based on a formula that is "pegged" to the U.S. dollar (USD). Why peg to the USD? For an emerging economy, pegging your currency to the world's reserve currency is one way to provide greater stability within a developing monetary system.
For many years, China pegged the yuan at an artificially low valuation. Because the yuan was undervalued in terms of USD, China could export lots of cheap goods to the United States. This bothered many people because it gave Chinese companies an unfair advantage over their U.S. counterparts. In 2005, under pressure from the international community, China began allowing the yuan to slowly appreciate and by 2014, the IMF considered the yuan to be fairly valued. Despite its fair value, China has always maintained strict controls over the currency and it is still somewhat pegged to the USD.
Back to this week...
Why did China decide to devalue the yuan? Well, over the past year, on the back of a strong U.S. economy, the USD has increased in value by nearly 20%. The yuan, still being closely tied to the dollar, followed suit. The Chinese economy however, has been weakening, and a slowing economy with a rising yuan is problematic.
With a strong yuan, Chinese goods have become more expensive in other parts of the world. Higher cost leads to less demand. Slowing demand has led to fewer exports and this has been an added drag on the fragile economy. By devaluing the yuan, the Chinese government is hoping to jumpstart Chinese exports by making them more affordable (thus attractive) in other parts of the world again.
So if devaluing the yuan is going to help China, then why did stock markets around the world sell off on this news? Well currency valuations work both ways. When the yuan depreciates, the rest of the world can buy Chinese goods cheaper. But, a cheaper yuan also means that goods from Europe and the United States will be more expensive for consumers living in China to buy. There are A LOT of consumers in China. In fact, China is the third largest importer of goods in the world. If those goods are more expensive, that means less demand for European and U.S. products. How much less demand? It could be significant enough to impact the economies of many other nations who rely on China for sales. If you weren't aware, the Chinese buy a lot of iPhones.
In the grand scheme of things is this really a big deal? I doubt it. Most people have been begging the Chinese for years to loosen the USD peg and let market forces price the yuan. That is exactly what they are doing, albeit slowly. To me, the "Currency War" doomsday headlines are driven more by 24/7 newsrooms starving for stories during the slow summer months, than the real possibility of a currency crisis.
Anyway, if you didn't understand how foreign exchange markets affect international trade, I hope you now have a better idea. Have a yuan'derful weekend!
It's 5 o'clock somewhere...