This article was written by Nick Kalivas, a Senior Equity Product Strategist for Invesco PowerShares Capital Management LLC, a registered investment advisor that sponsors the PowerShares family of exchange-traded funds (ETFs).

In the face of economic weakness and continued capital outflows, China devalued its currency, the yuan, on Aug. 11 and 12, fixing it a total of 3.5% lower against the US dollar.1 While the dual devaluations clearly rattled the markets, China’s move is consistent with the volume of capital outflows the country has endured since late 2014.

There are a number of reasons behind the devaluations by the People’s Bank of China (PBoC):

  • Outflows. China’s continued outflow of capital has escalated sharply in recent months. China has lost an average of $42 billion in outflows per month over the past year, as shown in the chart below.1 China’s weak economy, excesses in the equity and real estate markets, and reduced competitiveness have all contributed to the outflow of capital. The Chinese government has made moves to open its foreign exchange market, but if outflows remain persistent, continued currency devaluation is likely. There is, in fact, very weak demand for the yuan given recent levels of capital flows.

  • Economic weakness. China’s economy is heavily dependent on exports, and slumping overseas shipments have crimped the country’s economic growth. Electricity output in China dropped 2.0% in July,1 while exports fell 8.3% on a year-over-year basis.2 Chinese manufacturers were hurt in part by a strong yuan, which is closely tied to the US dollar. Domestic demand is also flagging. In July, passenger car sales in China contracted 6.6% on a year-over-year basis, and overall auto production fell 26.3% from the previous year.1 China is a major auto market, so this is damaging to automobile exporters and their suppliers. Slumping auto demand is a sign of weak consumer spending and is likely a result of the country’s stock market crash.

Chinese Car Sales

  • Stock market crash. The Chinese equity market has moved sharply lower over the past two months, with the Shanghai Composite Index off 24.9% from its June 12 highs.1 Chinese consumers are heavily leveraged, with margin debt outstanding at 870 billion yuan — roughly double last year’s levels.1 It’s likely that China’s stock market crash was partially behind the government’s decision to devalue.
  • Competitive dynamics. For many years, the Chinese government had favored a strong yuan to steer Chinese consumers toward consumption and the economy away from low-end manufacturing. The latest moves by the PBoC mark a sharp policy reversal. Because the yuan so closely tracks the US dollar, its value has risen far out of line with economic fundamentals. The PBoC would like to make the yuan more responsive to market forces, and ultimately position the yuan as a major global currency.

Because the yuan is, by some estimates, roughly 10% overvalued, China’s decision to devalue the yuan is not entirely without merit.3 After all, a strong currency makes a country’s exports less competitive, which is bad news for an export-dependent powerhouse like China. But there is now the risk of continued devaluation, which could lead other countries to devalue their currencies as well. A devalued yuan also hurts companies that export to China by making their products relatively more expensive to Chinese consumers. Already, the yuan’s devaluation has had an adverse effect on the shares of luxury goods providers, consumer electronics firms and industrial machinery makers.

Fortunately, investors have options for navigating potential market volatility. If there is further dislocation in the global economy, we could see a renewed flight to quality and a focus on companies with stable earnings and dividend growth. The PowerShares S&P 500 High Quality Portfolio (SPHQ) is a smart beta ETF that focuses on these types of high-quality names.

A low-volatility approach may also make sense for investors who expect to see heightened market turbulence, or even a renewed currency war. Volatility, in the form of The CBOE Volatility Index (VIX), was up slightly following the initial devaluation to just above 13.0.1 The VIX has been trading in the mid to low range for the past year, and hints that the market is pricing limited risk. The PowerShares S&P 500 Low Volatility Portfolio (SPLV) is designed to help mitigate market volatility. The fund’s underlying index invests in 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months.

1 Source: Bloomberg LP, August 12, 2015

2 Source: Reuters, August 8, 2015

3 Source: Reuters, August 12, 2015

Read more about Chinese currency policy.

Important information

Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. An investment cannot be made into an index.