There were two dogs that did not bark this year. There are the Japanese yen, which despite negative interest rates and an unprecedented expansion of the central bank’s balance sheet, the yen has strengthened 15% against the dollar. The yen has been the strongest major currency, and the third strongest currency in the world behind the high-yielding Brazilian real, recovering from last year’s drop, and the Russian rouble, aided by a rebound in oil.
The other dog that is not barking is the China. In August 2015, and again at the start of is year, the decline of the yuan and weakness in Chinese equities reverberated around the world. It was even cited as a factor influencing the timing of the Fed removing accommodation. Since early this year, the yuan has continued to depreciate, and Chinese shares are among the worst performers. Yet it has not been a disruptive force.
The Shanghai Composite has fallen 11.5% this year. MSCI Emerging Market Index has gained about 14%. MSCI Asia-Pacific Index has advanced roughly 6% this year. MSCI’s World Index (developed markets) is about 4% higher on the year.
China’s reserves have fallen by about $134 bln in the first nine months of the year. This understates the capital outflow as China also recorded a $134 bln current account surplus in H1 16 and a trade surplus of $146 bln in Q3. Brad Sester of the Council on Foreign Relations, estimates that China may have experienced outflows of $95-$100 bln in Q3. As China sells reserves, it is selling US Treasuries. The latest country breakdown covers the month of August. US data, which is not necessarily comprehensive, estimates that China sold $33.7 bln of Treasury Securities in August after selling a combined $25.2 bln in June and July.
Without complicating the picture by attributing Belgium’s activity to China (as some want to do since China may use clearer and custodian there), US data shows China having divested US Treasuries in six of the first eight months of the year. In the past, and occasionally still, one can read pundits claiming US dependence on China funding its deficit. China’s sales of Treasuries has not prevented a decline in US yields this year. The 10-year yield finished last year near 2.27%. Today it is 50 bp lower.
The yuan is off 4.2% this year to trade at six-year lows against the US dollar. The dollar rose 4.65% against the yuan in 2015 after a 2.5% gain in 2014. The dollar had fallen against the yuan after officials abandoned the peg in 2005. Yuan rose against the dollar every year from 2005 through 2013. During the period around the Great Financial Crisis (mid-2008 to Q4 2010), it appears that officials had re-pegged the yuan. Since bottoming in January 2014, just below CNY6.04, the dollar has appreciated nearly 12.4% against the dollar.
Why aren’t the developments in China having a greater impact on global markets? We suggest there may be several reasons behind the seeming disconnect.
First, we suspect that the surprise and uncertainty over intentions led to an exaggerated market response in the summer of 2015 and earlier this year. The Chinese stock market, for example, is dominated by retail funds and has little relationship to the Chinese economy. China stocks have also stabilized. In July and August 2015, the Shanghai Composite fell 14.3% and 12.5% respectively. It fell 22.6% in January 2016. Since March, it has moved no more than 3.6% net-net in any month. Similarly, in August 2015, the dollar rose 2.7% against the yuan. Its monthly moves have been much smaller. October could see the biggest monthly move since August 2015, and the yuan may fall about 1.8%.
Second, the yuan’s decline has also been modest when compared with other currencies this year. Among emerging market currencies, Mexican peso and Turkish lira have fallen further, not to mention the Argentine peso. Among the majors, sterling is off 17%, and the Swedish krona has fallen 5.6%.
The yuan’s devaluation is also modest in terms of impact on Chinese exports. Due to the structure of Chinese industry, yuan incurred input costs in the country’s exports suggest the depreciation is insufficient to have much impact on Chinese competitiveness. Exports (and imports) are lower on a year-over-year basis. This offers prima facia evidence against claims that currency depreciation is reigniting exports for a slowing economy.
Third, the US Treasury seems somewhat more relaxed about the yuan. Rather than escalate the tension between the world’s two largest economies, the depreciation of the yuan has not spurred a backlash from the US. Even under the new criteria offered by the Treasury Department, China still does not meet the criteria of a currency manipulator.
Fourth, the Federal Reserve has signaled its intention to hike rates before the end of the year. Even Evans, the dovish Fed President from Chicago recently suggested three hikes before the end of next year may be appropriate. The Federal Reserve’s broad trade-weighted measures of the dollar have risen in four of the last five months (through September). The yuan’s weakness is partly a function of a stronger dollar. The yuan has depreciated slightly against the basket that PBOC has adopted (though many people and businesses, of course, continue to take decisions based on the dollar-yuan rate).
Fifth, the PBOC has been intervening to slow the yuan’s descent. If it were intervening to push the yuan, as it has sometimes in the past, it would be accumulating reserve assets, not liquidating them. Market forces, which Chinese officials have pledged to embrace, appear to be pushing the yuan down faster. Chinese intervention is to smooth out and make more orderly the yuan’s decline.
The performance of Chinese markets and the yuan can once again erupt onto the global stage and disrupt the capital markets. However, the role of the yuan and Chinese stocks in the world economy is modest, and the current pattern may be more sustainable than its markets dictating the investment climate.