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China Crisis?

Summary

I suspect that most of the readers of this blog are too young to remember the ’80s group of the same name who are still going and currently undergoing a nationwide tour. Although not one of my favourites, they’ll most likely be appearing in a town near you. No matter, this isn’t about them. It’s about the events of last week and financial markets’ reaction and commentaries on why China devalued its currency, the yuan, on consecutive days.

I suspect that most of the readers of this blog are too young to remember the ’80s group of the same name who are still going and currently undergoing a nationwide tour.  Although not one of my favourites, they’ll most likely be appearing in a town near you.  No matter, this isn’t about them.  It’s about the events of last week and financial markets’ reaction and commentaries on why China devalued its currency, the yuan, on consecutive days.
Readers may recall in our last blog, ‘For FX sake!’ last month, we wrote about how a weak euro was a key part of the European Central Bank’s quantitative easing programme.  So was last week’s yuan devaluation another example of deliberate currency weakness by a country or region to assist economic growth?
We think not for the following reasons.

  • China is on a path to open up its economy and internationalise its currency as part of a plan to become a greater economic force within Asia and globally.
  • Last year’s attempt to drive the Chinese domestic stock market higher was flawed as any strategy built on offering massive leverage to the man in the street is likely to both run out of steam and then endure a precipitous fall. Which is what happened.
  • Nevertheless, the Shanghai Stock Exchange Composite Index is up over 70% over the past year although 24% off its highs, yet up over 17% year to date at the time of writing this blog.

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Source: Bloomberg
Given the shenanigans that the Chinese authorities went through to stabilise their stock market, some ‘face’ has been lost in the international community, magnifying the need to be seen to be doing something else to move towards making their currency freely usable and opening up China’s capital account.

  • As the world’s second largest economy, China is keen to demonstrate ‘smooth’ progress towards capital market liberalisation. Removing the exchange rate straitjacket provides for a more balanced and flexible exchange rate policy – especially important as inflation is currently very low by Chinese standards.
  • One look at how much the Chinese renminbi has appreciated in real terms over the past ten years gives you a sense that last week’s moves were the start of a mechanism for greater flexibility and an awareness of what China needs to do to gain reserve currency status on the road to greater international influence and acceptance.

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The immediate goal is for the renminbi to be included as part of the special drawing rights (SDR) currency basket when the International Monetary Fund has its five year review of the SDR weights in November this year.
As the English Premier League has entered its second week, I guess you could say that given the Chinese caught the markets napping, yuan – nil to China!
The T. Bailey funds have little exposure to China although as the world’s second largest economy, it is an important influence on our strategic asset allocation particularly in an Asian context.  Our Growth fund had a small explicit exposure to China from May 2014 as we believed the economic slowdown fears were overdone. This was removed in June 2015 after our analysis highlighted the amount of leverage at work in the local stock market’s upward momentum.  Presently, Chinese exposure rests with our Asian index-agnostic, conviction managers who have the ability to find individual companies at attractive valuations.
Footnote: The renminbi is the name of China’s currency much in the way that people refer to sterling in reference to the UK’s currency.  The unit of China’s currency is the yuan as the pound is for the UK’s currency.  The international code for China’s currency is CNY as GBP is for the UK.  Renminbi means people’s currency.

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