Currency War Rages on as China Devalues Yuan

PBOCChina’s central bank has caught the markets off-guard by unexpectedly devaluing the yuan by nearly 2 percent against the U.S. dollar, roiling stocks as a result, especially those that sell to China. The central bank of China has tried to brush aside the magnitude of the move, calling it a ‘one-off depreciation’ and saying the change in policy will help drive the currency toward more market-driven movements. However, this is just another chapter in the worldwide currency war we are experiencing, and it should not come as a surprise at all.

First, it is helpful to examine more closely what China actually changed. The yuan has been pegged to the dollar for many years now, with Chinese officials allowing the yuan to trade 2% above or below a midpoint they set called the daily fixing. Officials can look at the daily trading when setting the midpoint, or they can arbitrarily set it higher or lower as they please.

The central bank has now changed its policy, saying it will base the midpoint off of the previous day’s closing price as well as market-makers’ quotes. As a result, it set the midpoint 2% lower than the previous day’s. This was the biggest devaluation of the yuan since 1994 when they let it fall by one-third as part of a breaking away from Communist state planning.

Because the rules are now more ‘market based’, it will be interesting to see if this really will be a one-off devaluation or if China will let the currency slide further. They could also continue to influence rates by entering the foreign exchange markets themselves with their reserves.

In the end, the mechanism or specifics are minor details compared to the real reason for the devaluation; participation in the global currency war. Almost nobody doubts that China is now fully engaged in the same game that developed countries have been playing for years now. Each one is devaluing their national currency as a last-ditch effort to stimulate more growth.

Remember that greater GDP is the holy grail of growth, especially for the still largely state-planned economy of China where GDP growth targets are always met, without exception. It has not gone unnoticed that China’s economy may be slowing. Since net exports are part of the GDP calculation, then devaluing the domestic currency makes exporting easier for a country, because goods will be cheaper relative to others.

What does this mean for the rest of the world, especially savers and investors? Normally, if a country decides to shoot themselves in the foot and try to achieve wealth by devaluing their currency, other countries can benefit at their expense. For example, Chinese imported goods will be cheaper for Americans and others who import them.

But this is only the immediate effect. The problem is that currency wars are a grand game with moves and countermoves, played between sovereign nations and leaders around the world. Other countries struggling with GDP growth, which at this point is almost everyone, will also feel the pressure to devalue their currencies, hence the currency ‘war’.

Savers in countries that choose to join in the war will suffer because the currency they are saving will depreciate. Conversely, it will be good for gold and other precious metals and hard assets. The U.S. dollar has so far been fairly strong over the last year which is one of the reasons gold has declined in U.S. dollar terms. But note that for other countries that have depreciated their currencies more, gold is still in positive territory over the last year, such as in terms of yen or euros.

Finally, another problematic outcome of this could be trade wars. Don’t be surprised if nations once again start calling the Chinese ‘currency manipulators’. Businesses that primarily export to China will indeed be at a disadvantage in the short-term. This could lead to some calling on the government for protectionist policies such as quotas, tariffs or subsidies. Once one country enacts these measures, the other trading partner may retaliate, the currency war then becomes a trade war where nobody really wins and everyone loses, especially consumers through higher priced goods.

In conclusion, China’s ‘surprise’ devaluation shouldn’t be that unexpected for students of history and those who understand that governments will try any policy to induce economic growth, even if it is only temporary and ultimately harmful. In the meantime, savers and investors should move out of investments linked to these currencies or companies that export to these countries. In addition, they should also continue to protect their wealth in hard assets.

Chris Kuiper CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.