24 August 2015
The recent devaluation of the yuan has created a great deal of "confused signaling" as the world tried to understand the purpose of the relatively sudden shift in exchange rate over the span of just a few days. The exchange rate has moved by at least 3% not only for the dollar, but also the Euro and yen. Many of the reactions publicized in the wider media are over-reactions, with expectations of far-reaching implications often greatly exaggerated.
This is not the start of a trade war, as some pundits have led us to believe. I believe the change was not motivated by a desire to boost exports or use exports to boost domestic employment. Consider that exports have not been a major tool for Chinese economic growth for close to a decade. Since then, economic growth has largely hinged on investment in fixed assets, and on the much-awaited move towards greater consumption. The recent changes would hardly "move the needle" with export volumes as demand overseas remains weak, especially from Europe and Japan. The devaluation is not a short-term form of stimulus to buy additional time for domestic reform, as most short-term stimuli are designed to do. An exchange rate move is not a significant stimulus tool in comparison to RRR cuts or interest rate cuts.
Could it be about special drawing rights (SDRs)? Perhaps. An important path to becoming a reserve currency is to make it less actively managed and more market-driven. One of the proposed explanations of the devaluation is a one-off adjustment to the foreign exchange fixing rate to relieve downward pressure that had built up recently. A wider trading band and more transparent market-oriented fixing rate are both essential parts of the currency reform process.
That means allowing the currency to move, and this is considered a pre-condition to becoming a global reserve currency. In other words, short-term pain for long-term gain. In this sense, the bulk of the depreciation in this one-off move has already taken place and additional moves might be rather limited.
Consider the wider economy for a moment. There are many well-recognized issues in need of deep reform to ensure future economic prosperity. Some of these, such as land reform, and the social services system, are very complex issues that have many competing interests. However, currency and interest rate issues happen to be relatively more straightforward, with fewer competing interests. A change to the fixing rate, or the interest rate, can be made to happen relatively swiftly.
The dollar has been rising against other emerging market currencies for quite some time, the yuan being the most obvious exception. It is only logical that the yuan would have to be brought in line, to some extent, with what appears to be a global trend. Also, adding to this is that the fundamentals behind the Chinese economy are not as strong as they once were, and the yuan's depreciation is a reflection of its true value. Meanwhile, the US economy has shown solid footing in its recovery.
Who are the winners?
Consumption of goods and services abroad will be slightly more expensive. Is this enough to lead consumers to think twice about overseas travel and overseas shopping sprees? Probably not. Overseas travel to Japan, a current favorite, and with a still-favourable exchange rate, will remain as popular as ever.
It is also worth mentioning that the price reductions for imported goods gained through the recent import tariff cuts were wiped out by the currency move. Reports of retailers seeing their earnings projections affected are starting to appear. But the real story is with capital flows.
China's one-way path to appreciation was, for almost a decade, icing on the cake for foreign inbound investors buying commercial property in China. Currency appreciation by itself was insufficient to build an investment case, but was a welcome bonus – a boost to home-currency returns. Although in most cases, the liquidity premium (the cost of exiting from the market) would erode most currency gains at the time of exit of the investment for foreign institutions.
Before the devaluation, foreign direct investment in real estate was already dampened by high prices, and a weakening growth outlook. The recent move adds to this by making investors question future assumptions about cash flows on their China investments when converted into home currency. This makes inbound investment into China worthy of a careful pause. In limited cases new market entrants or capital raisings mandates for China focused funds may be delayed until a certainty can be achieved for managing returns and setting up partial hedging agreements. However, investors with China-focused mandates will continue to look at China. Foreign investors will likely wait and see, causing a temporary stall in decision making over the coming weeks and months.
The surge in outbound capital flows, real estate included, has been tremendous in the last one to two years. Could the devaluation be a crude capital control to stem this outflow? This is not certain. The devaluation has a temporary effect of raising prices of assets abroad, therefore discouraging outbound investment. However, an attempt to reduce outflows via devaluation will in fact encourage more capital outflows in real estate. The devaluation has the unintended consequence of encouraging Chinese real estate funds to diversify their assets globally in order to hedge currency risk. This will encourage more outbound investment. Outbound investors will benefit from stronger foreign-denominated cash flows, and see a tidy boost in total returns.
Housing in foreign countries may be slightly more expensive. But homebuyers who were contemplating an overseas purchase now have even more reason to do so in order to diversify their holdings. We can expect to see rising interest in outbound residential investment not only in a search for returns, or a search for rental yield, but now also as a wealth preservation tool. Top choices for investment destination will continue to be global financial capitals like London or New York, with increasing interest in secondary markets globally. The recent move has alerted buyers to the need for more diversification across geographies and may raise the interest level for properties yielding hard currencies. More importantly, they will be closely watching for the establishment of a new trend.
One might argue that what goes up must come down. All currencies move in cycles, just as the dollar itself has over decades. For now, everyone is in wait-and-see mode.