China’s authorities have made it clear through verbal and financial intervention that they feel uncomfortable about excessive currency volatility. We would expect a firm hand on the tiller to help smooth a depreciation. Beijing has substantive tools at its disposal: gargantuan foreign exchange reserves, close control over the conduits of domestic finance, a current account surplus and a near-monopoly on yuan assets held on shore. A slow and managed depreciation would not surprise me.
Where does this leave EM assets? Weak or falling domestic demand and trade growth, an appreciating U.S. dollar and slumping commodity prices have already taken a toll. The prospect of a weakening yuan and subsequent rounds of competitive EM currency depreciations make matters worse. They only add to other challenges such as dwindling corporate profits, declines in productivity and a dispirited investor base. At the very least, losing the anchor of a near-fixed exchange rate raises volatility. EM assets are starting to look cheap, but it’s too soon to grasp this particular nettle, as I wrote the other week in ‘Emerging market equities: close but no cigar‘.
So which is it? A yuan yawn or nightmare? Neither one appears appropriate at this time. It is more than a yawn, particularly for the emerging world. Yet it is hard to see it quickly morphing into a nightmare. All we know is that the yuan is an important yarn with an unknown ending.
For Chinese citizens, the yuan depreciation appears a side show for now. The story did not show up in the top 10 most popular searches on China’s domestic search engine Baidu on Thursday (not for the day and neither for the week). The currency news was edged out by entertainment gossip, crime, the explosion in the harbour city of Tianjin and a NASA robot cruising the planet Mars transmitting an image of what looked like a woman, the website showed.
The yuan yarn could dissipate from global financial markets as well. Markets care about the shark closest to the boat, as my colleague Rick Rieder says. They are unable to focus on more than a single issue at a time. The next cab off the rank is next month’s U.S. Federal Reserve meeting–when we expect the central bank to raise interest rates for the first time in almost a decade. Federal funds futures contracts had slipped to pricing in less-than-even odds for a September rate increase by Thursday, according to Bloomberg data. This appeared to be one of the biggest overreactions of the week’s febrile markets.
This is a guest post by Ewen Cameron Watt, London-based Chief Investment Strategist for BlackRock and the BlackRock Investment Institute.