The Chinese government allowed its currency, the yuan, to depreciate nearly 2% against the dollar on Tuesday (as we anticipated it would eventually do). A slightly weaker currency should help—on the margin—export competitiveness and drive up import prices for China. That’s not a bad combination, as China’s inflation rate is 1.6% year over year and its exports have been suffering. The move also helps the Chinese government make the case for the yuan to eventually become a global reserve currency, as institutions like the International Monetary Fund have thought there has been too much government meddling in the pricing and exchangeability of the yuan. Combined with monetary stimulus and fiscal stimulus, this exchange-rate stimulus is emblematic of the way the Chinese government is stoking the flames of growth: a little bit at a time.
Don’t expect the start of a currency war
Putting the recent move by the Chinese government into context can help allay fears that this might be the start of a currency war, where governments try to drive down their currencies’ values to the detriment of their neighbors. The yuan depreciated relative to the dollar up until the beginning of 1994. Then the Chinese government began to effectively peg the value of the yuan relative to the dollar. In the middle of 2005, the yuan slowly began to appreciate relative to the dollar. In 2011, the Chinese government allowed the yuan to fluctuate a bit more against the dollar. The latest step is part of a long-term plan to allow the yuan to be determined more by market forces than by government fiat.
Source: Federal Reserve Economic Database
From the beginning of the year until August 10, most Asian currencies have depreciated relative to the dollar. The exceptions have been the Hong Kong dollar—which is pegged to the U.S. dollar—and the Chinese yuan. China isn’t triggering a currency war. It’s just catching up to its neighbors.
Bonds rallied at the news of China’s currency devaluation
The knee-jerk reaction of the bond market to the Chinese devaluation was a rally in Treasuries. The yield on the 10-year note, which was around 2.45% a month ago, is 2.16% now. The rally of the past several days has been in response to weaker commodity prices and falling equity markets. Apparently, participants in the Treasury market assume that China’s action will exacerbate those trends—if there is a continued devaluation, the Chinese government would likely buy more Treasuries to push the yuan down. We don’t believe the Chinese government will have to devalue its currency much more than it has. This is just a change in the regime from a tightly managed float of the yuan to a more market-based approach to setting the exchange rate.
For the same reasons Treasuries have rallied, high-yield corporates have been hurt, especially the energy companies. The yield on the Merrill high-yield master index is back above 7%. It reached 7.25% in December when oil prices plummeted; it then fell to below 6% in April–May and is now around 7.15%. If Treasuries are overreacting to the drop in commodity prices and to China, so is the high-yield market. High-yield bonds now look like an excellent bargain to us.
A slight boost to global growth and Chinese equities, but likely won’t affect the Fed’s thinking
Global stocks sold off on the news, but that seems like one more knee-jerk reaction. To the extent that the devaluation is successful in boosting economic growth in China, it should also boost demand for raw materials and give a slight boost to global growth. This is not a beggar-thy-neighbor act. It should be a small net benefit to the world economy. China has many policy levers at its disposal and still a long way to go with more market reforms. That’s a positive for Chinese stocks and the global outlook in general.
More important, China’s currency devaluation will probably not influence the Federal Open Market Committee in mid-September. It will (we think) decide to start raising the federal funds rate because it believes the U.S. economy can tolerate such a move. Growth is now sufficiently healthy to withstand a small increase in short-term rates.