For a second day the Chinese currency’s value has plummeted resulting in a cumulative greater than 5% depreciation of the offshore currency (the onshore currency will have moved approximately the same). This is a hugely significant moment in 2015. The first or second largest economy in the world doesn’t devalue its currency without tremendous consequences and ripple effects throughout the global economy. The most obvious end result of the events of the last few days is that in my view the possibility of an interest rate hike in the United States in the next few months is now seriously in jeopardy. Here’s why…(1) a Chinese devaluation is a deflationary event. Chinese export products will now be cheaper in world markets so consumers will experience lower prices, i.e., disinflation; (2) China is exporting their slowing growth to the rest of the world as their competitors will now be disadvantaged by having to compete with cheaper goods in world markets. This will be a negative growth event for competitor economies (3) commodity markets will be adversely impacted by the Chinese devaluation as it will be that much harder for them to sell their now more expensive products in China unless their prices adjust downwards. Obviously this means less revenue for resource rich economies, and another vector through which deflationary pressure will ripple around the world.
Equity markets have tumbled in response to the news coming out of China, no doubt because of the direct impact on exporter earnings of a more competitive renminbi, but also because of the uncertainty surrounding the implications on geopolitics. We are heading into an election year in the United States, Presidential candidates are unlikely to take the Chinese devaluation lightly and it’s hard not to imagine a hostile response. Quite what that will be, no one knows, and markets will not like that. Over the last year I have repeatedly discussed my concerns about the hard currency debts of corporates in Emerging markets. One of the largest issuers of dollar debt have been Chinese corporates. Perhaps retail investors in China were on the right track when they started dumping their shares a month ago. One can only imagine the difficulties some of these companies will now face with their dollar debts that bit more expensive in renminbi terms. There are consequences upon consequences to this currency move, and please bear in mind that other Asian currencies have weakened sympathetically, these other Asian economies also have accumulated large amounts of dollar debt. The global financial system is a more risky place than it was at the start of the week, it will take some considerable time for us to fully understand how much more so.
The euro, as the world’s carry currency (or you could say funding currency – traders who leverage will borrow in euros to fund more risky investments) has appreciated considerably today. This is normal, as risk sentiment becomes more negative those who would leverage carry currencies tend to unwind their risky positions. This will naturally lead to the carry currency being repurchased to close out the trading position.
The imminence of rate hikes in the United States was always going to expose vulnerable economies, the events of this week have seemingly accelerated the process. From Singapore’s slowing economy to Chile suffering the consequences of falling copper prices, there are many narratives that highlight the multitude of risks facing the global economy. There are positives as well, please don’t misunderstand, an example would be the better mortgage rates available to house buyers in the UK, with interest rate hikes receding, but do not underestimate the problems brewing in developing countries. We will continue to assess the situation, the devaluation of the renminbi represents an event that is consequential enough to alter our assessment of the most likely path for major currencies, it will take time to update our narrative. Things have changed.
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