Back in March, I was saying that China would be hard-pressed to maintain its dollar peg if a strong dollar persisted. The deflationary pressures in China are simply too large. Today we learned that it has finally succumbed to that pressure and devalued its currency outright. I see this as a big move in the currency wars and a key marker of signs of economic distress.
Now, yesterday I was heralding the transformation of China as marginal buyer of last resort to exporter of deflation worldwide as the biggest macro theme in the global economy right now. My thesis was the following:
- The US economy is doing well enough that the Federal Reserve is now probably poised to raise interest rates at least once
- Since every other major and emerging market central bank is moving toward greater policy ease, this supports a strong dollar
- The Chinese, fighting a debt problem and slowing growth, will stop acting as a marginal buyer of industrial commodities and raw materials
- The result will be increased disinflationary and deflationary pressure worldwide
I believe the Chinese currency depreciation fits well into this narrative. The Chinese control their currency via a fixed but crawling peg to the U.S. dollar. They set a daily rate that over the years has steadily seen the Renminbi appreciate significantly in value versus the U.S. dollar. Chinese domestic currency traders are allowed to trade within a widened 2% channel. But recently, the renminbi has been consistently trading at the lower end of that band, meaning traders have signalled that the Chinese currency is overvalued, not undervalued. What traders are signalling is that the economy is so weak now that the currency release valve should see the Renminbi weaken versus an appreciating dollar, given the recent interest rate cuts and other easing moves by the People’s Bank of China. The PBoC has not taken these signals onboard until today, when it devalued the currency.
If you go back to January, I wrote the following: “if the U.S. continues on this divergent path we are going to get reflexivity and overshoot versus the Canadian Dollar, the Euro, and emerging market currencies. China cannot possibly hold its peg to the U.S. dollar under that circumstance. And they will be forced to widen their band and attempt to force depreciation. When China joins the currency wars, it will export deflation and change the whole tenor of the discussion.”
The March prior, the Chinese had already widened the trading band to 2% on 16 Mar. But that was all I was predicting – more of the same. I said nothing about outright depreciation. In fact, I remember a March Twitter conversation with Eric Burroughs, Greg Ip and George Magnus in which I talked about the situation. It was a good back and forth. I recommend you follow the whole conversation by clicking the links below.
“if China devalues; that would kick off a currency war.” – @greg_ip https://t.co/oioP4L3BTw
— Edward Harrison (@edwardnh)
“When China joins the currency wars, it will export deflation & change whole tenor of discussion.” @edwardnh https://t.co/lXzlORU9kB
— Greg Ip (@greg_ip)
“The People’s Bank of China will continue to increase the two-way flexibility of the renminbi exchange rate” @greg_ip@georgemagnus1
— Edward Harrison (@edwardnh)
The thrust of what I was saying in March is that the Chinese wanted to have their cake and eat it too, meaning they wanted to increase the internationalization of the Yuan and make it part of the IMF’s special drawing right currencies but also support economic growth via exports. Widening the Renminbi trading band accomplished both these tasks. On the other hand, a unilateral devaluation would be seen as non-compliant by the US and upset China’s ability to get into the SDR, I believed.
At the same time, we were all saying that China’s devaluation would be a major move in the ongoing currency wars, a signal that they were desperate because the economic situation had deteriorated to the point where the Chinese were forced into unilateral currency moves.
Albert Edwards predicted all of this though. A week before the March twitter conversation on band widening that preceded the actual event three days later, I posted Alberts thoughts on the issue at Credit Writedowns. His view: “China’s growth and deflation problems will necessitate a devaluation of the renminbi in a strong dollar environment.”
Now that the devaluation has occurred, let’s look at the context in terms of what has changed between now and March. First, the Chinese economy continues to slow, with the economy likely much softer than the official 7% growth number. Second, the Chinese are also dealing with a property and stock market crash as well as incipient capital flight. These two events are game changers in terms of Chinese decision-making and necessitated the devaluation.
But the commodities environment is clearly worse. And that means that a Chinese devaluation makes commodities more expensive for Chinese importers, thus putting downward pressure on the whole commodities complex. The Chinese are now officially exporting deflation. Let’s see how markets and governments react. No matter what happens though, this is the biggest marker yet that the economic and market stress coming to bear on emerging markets, energy high yield, and commodities will be unrelenting.