Since the devaluation of the Chinese Yuan in August, the US dollar has appreciated by over 6% against the currency, with the PBOC undertaking a further devaluation most recently on January 6th (see chart).
The adverse impact the devaluation has had on global financial markets reflects the signalling effect; in much the same way that a cut to dividends signals to investors that the insiders are concerned about a company’s future growth prospects, market participants have inferred from the devaluation that Chinese authorities have a pessimistic view about the economy’s growth trajectory.
These concerns are well founded: manufacturing and industrial production remain in a funk (see chart), renewed volatility in the Shanghai Composite Exchange has rattled confidence, and many residential and commercial property markets are suffering from an inventory glut. The authorities' efforts to stabilise the stock market also probably contributed to a crisis of confidence.
What seems to have gone under the radar in much of the press and commentary is that the Chinese Yuan (CNY) has undergone a significant appreciation in recent years. In real or inflation adjusted terms, the CNY has appreciated by 60% against a basket of its major trading partners over the past decade. In contrast, the US dollar effective exchange rate is only now back at the level that prevailed a decade ago (see chart). The real appreciation of the CNY amounts to a significant tightening of monetary conditions in China.
The classic symptoms of a domestic cyclical downturn besetting China are tied up with the strong appreciation of the currency over the past decade. This is not to deny China's many structural challenges, including much needed reform of the financial system and re-balancing of growth towards consumption. Such structural reforms are necessary to help China achieve sustainable growth over the medium term. But China is also currently suffering from deficient demand and an ongoing re-alignment of its currency and the associated monetary stimulus represents an appropriate policy response.
Indeed, the CNY would likely have long depreciated if it had been a floating currency. The PBOC has not put up the white flag; it is right to seek to re-align the currency with the economy's fundamentals. The scale of the real appreciation on the CNY over the past decade and weakness in manufacturing sectors suggests that further and significant devaluation is a likely prospect. Any such re-alignment will help to stimulate the economy and unwind some of the decade long appreciation.
If the PBOC can see through the market turbulence and keep its resolve to stay the course with further devaluation, this should help to stabilise the manufacturing sector and property markets. Against this backdrop, there promises to be significant upside to commodities from current levels. But not just yet.