As China struggles with its continued slowdown, we see a distinct possibility that the authorities will try to regain manufacturing export competitiveness through devaluing the Yuan. The timing is likely to be complicated by the IMF’s decision on inclusion of the Yuan in its official currency basket, but ultimately we think the compulsion to devalue will prove too much. This could lead to a wave of global deflation and also put more pressure on US profitability, where corporations are already struggling with the strong dollar.
As we have covered before, China is suffering from a loss of competitiveness that is contributing significantly to its current slowdown. From double-digit growth through the early noughties, the credibility-light official figure continues to suggest an economy in decline with the latest official figure for the second quarter of 2015 coming in at just 7% (see chart below). Some other analyses suggest the true figure is actually even lower, and could well be below 4% .
OFFICIAL CHINESE GDP HAS FALLEN TO 7%
For most of the last twenty years China has been an export-driven power house thanks to cheap labour as well as a favourable exchange rate, kept down by the authorities, much to the chagrin of others economies, particularly the US. Since then, Chinese competitiveness has been falling largely through a combination of potent wage growth, misallocation of capital to uneconomic projects and a damagingly strong currency.
As the government struggles to re-ignite economic growth through enhancing competitiveness, it seems ever more likely that they will look to achieve this through currency devaluation, as the most easy and palatable (domestically) option available to them. Although this somewhat runs against the current reform agenda aimed at rebalancing the economy away from export and investment led growth towards a more stable consumption-based economy, it is clear that the Chinese government feels it needs to do something to kick start growth, particularly as it struggles to address the high levels of debt accruing across the economy.
For a long time, the Chinese authorities have actively controlled the currency through interventions designed to keep it pegged to the US dollar, rather than letting it freely float. Over time, however, the authorities have allowed this peg to move, and during the last ten years the yuan has appreciated around 30% relative to the dollar.
CURRENCY APPRECIATION OF THE CHINESE YUAN (CNY) RELATIVE TO US DOLLAR
This appreciation was tolerable in the post global-financial crisis period when the dollar was relatively stable on a trade-weighted basis. However, over the last twelve months the dollar has surged, and the peg has meant the Chinese yuan has been dragged up along with it. This has left China considerably less competitive on exports (see next section), and an obvious route to restore some of this competitiveness would be to depreciate the currency – which is particularly easy to do when your exchange rate is centrally controlled by the government.
It is also politically less sensitive. Whilst, until recently, the US believed the Chinese were unfairly manipulating their currency downwards, the International Monetary Fund (IMF) has now declared that it believes the Yuan is no longer undervalued , which we infer as suggesting it is therefore overvalued. This view is supported by others, including analysis from Barclays who believe the Yuan to be 18% overvalued  based on effect exchange rates. Arguably, therefore, China could conceivably look to devalue the currency under the guise of liberalising the FX market towards the ultimate aim of a free-floating currency. Indeed, the Chinese State Council has already moved a step closer to this by once again announcing the country intends to widen the range within which the currency can trade, introducing further flexibility.
The problem is not just that China’s currency is potentially overvalued, but that many of its key competitors are activity devaluing their currencies. The chart below shows the real effective exchange rate (a measure of currency value against an inflation-adjusted broad basket of currencies) for China alongside the Euro and Yen, both of which are major export currencies.
YUAN AS APPRECIATING JUST AS MAJOR EXPORT RIVALS ARE DEVALUING
It clearly doesn’t seem sustainable to have a currency that is some 40% more expensive on a relative basis at a time when rivals are enjoying the benefits of a cheaper currency, caused in large part by ‘quantitative easing’ money-printing activities. At some point, there is the strong possibility that China joins in the global competitive currency devaluation game that is already well underway in Europe and Japan.
What’s holding them back?
The case for devaluing seems pretty compelling, so what might be holding them back? One reason is the mostly political objective of having the currency become a global reserve currency. A major step towards this is to be added to the IMF’s ‘Special Drawing Rights’ basket of currencies, which would effectively put the currency alongside the Dollar, Euro, Pound and Yen as currencies used to fund the IMF’s activities. The basket is reviewed every five years, with the next decision point due this autumn – though recent reports have suggested the IMF may take the unusual step of delaying the decision for a year. Earlier in the year, comments from senior IMF officials suggested the Yuan has a good chance of being included, and China has been working hard to meet the requirements, including opening up its bond markets to eligible parties such as foreign central banks.
The recent intense volatility in Chinese equity markets, and the extreme measures taken by the central government to stem the rout has raised serious questions over the credibility of the authorities. Nonetheless, their chances of inclusion haven’t been entirely scuppered, with IMF managing director Christine Lagarde suggesting the recent market turmoil would not impact the IMF’s assessment on SDR inclusion. With this in mind, there is a clear incentive not to aggressively devalue the currency ahead of the IMF’s decision later this year.
China seems to have very few options left to regain its competitiveness and foster much-needed growth. We therefore see a strong possibility that the Chinese authorities will look to devalue the yuan over the next 12 to 24 months. The decision by the IMF on including the Yuan in the SDR currency basket may influence the timing of any devaluation, but we suspect the compulsion to kick-start manufacturing export competitiveness will ultimately prove irresistible.
Clearly devaluation will be negative to domestic Chinese assets in the short-term, however the fund managers we use to access emerging markets and Asia Pacific tend to have very limited exposure to yuan-denominated assets. Of more concern is the potential wave of deflation that could emanate out across markets from the world’s second largest economy. Given how low inflation levels currently are, this could damage the global economic recovery by weakening consumer demand and increasing the real debt burden. Yuan devaluation could also further weaken US profitability by pushing the US dollar even higher and leaving them as the main loser in what amounts to a fresh currency war.
Overall, our house position remains to be underweight Asia-Pacific and Emerging Market equities, particularly China, whilst also holding underweight US equity positions. We recently took the decision to move incrementally towards a more cautious stance by marginally increasing our cash and absolute return exposures by decreasing fixed income overall to underweight and our equity exposure to neutral. This in part reflects an increased risk of China-led instability, though we note there are still a number of positives for equities, particularly in those regions that are engaged in QE-like programmes.
 Lombard Street Research, “Chinese cloud still only on US horizon”, 22/7/15