Chinese yuan devaluation surprises markets | ETF Trends

This article was written by Rob Waldner, chief strategist and head of the Multi-Sector team for Invesco Fixed Income.

In a surprise overnight move, China devalued its currency, the yuan, by 1.9%, the first time it has altered its exchange rate regime in more than 20 years.1 The People’s Bank of China (PBoC) said the move was a one-time adjustment that is justified by the yuan’s relative strength against other currencies and the timely need to make it more market-based. The PBoC also said that the yuan’s value will be based on daily market quotes going forward, rather than being determined solely by the central bank.2

Although the PBoC maintains it’s a one-time adjustment, it seems clear that China is moving to a system where the market will help determine the central yuan rate — hence, we have a sort of “dirty float”— a floating exchange rate system in which a government or central bank occasionally intervenes to affect the value of its country’s currency.  Invesco Fixed Income believes this means:

  • A continued decline in the yuan.
  • A continued rally in the dollar.
  • Downward pressure on long-maturity bond yields.
  • A choppy market for riskier assets, such as stocks and credit assets.
  • Finally, a more cautious Federal Reserve (Fed).

Why now?

The yuan devaluation may signal that China’s efforts to rebalance its economy toward greater growth may be proving more challenging than anticipated. According to some estimates, the trade-weighted yuan has increased by over 11% in the past year, and exports have been falling sharply — down 9.2% in July.1 A weaker yuan may help turn growth around by boosting China’s exports, but a roughly 2% currency devaluation is only a small step toward that goal.

In addition, Chinese authorities may have in mind their ambition to internationalize the yuan. Part of this effort is seeking the yuan’s inclusion in the International Monetary Fund’s (IMF) Special Drawing Rights basket (a basket of reserve currencies). 3 The IMF may view a more market-oriented currency as more desirable.

China’s challenges

However, given how complex and interconnected today’s financial markets are, a sudden change to a long-standing policy can often have broad reverberations. The challenges Chinese authorities now face are manifold, in our view, because the yuan’s devaluation may:

  • Encourage more, rather than less, speculation in favor of the dollar.
  • Set in motion broader depreciation pressures among trading partners, meaning we could be in store for significant depreciation among other Asian currencies in the coming months. Broader financial markets may also be negatively affected.
  • Discourage capital inflows into China and intensify capital outflows. The drain on China’s foreign reserves could tighten domestic lending conditions, just when the government aims to boost growth by easing them.

Implications for bond investors

Despite the economic weakness we’re seeing outside the US — and China’s devaluation appears to confirm its own growth struggles — the bottom line for the US is that it needs to tighten monetary policy. This can be achieved through two channels: higher interest rates or a stronger US dollar. We believe the yuan devaluation makes it much more likely that US tightening will be achieved through currency rather than interest rate channels.