China's Currency Devaluation: Possible Consequences

The shocks from the Chinese yuan devaluation continue to echo around the world.

Today, the currency had its second-worst day (after yesterday) since the modern Chinese foreign exchange system launched in 1994, falling a further 1.6 percent against the dollar. Markets were down around the world, and U.S. interest rates dropped substantially.

Another move in the currency war?

Many are interpreting the Chinese yuan devaluation as another shot in an undeclared currency war—a battle in which countries are trying to steal jobs and growth from their neighbors by cheapening their own currencies. It’s certainly not a crazy idea, as a cheaper currency will have that effect. Countries such as India, the Philippines, and South Korea are wrestling with that issue now. It’s hard to believe that China didn’t have the potential positive effects on growth in mind, as well as the potential political risks.

According to China, though, its goal was simply to make the currency more market oriented, in line with International Monetary Fund recommendations. Indeed, the IMF cautiously endorsed the move as potentially positive, increasing the yuan's chances of promotion to official reserve currency status, something the Chinese want.

You can also make a good case that the Chinese, by maintaining an unofficial peg to the U.S. dollar, have a currency that should depreciate, as the market is showing us. Again, the IMF noted earlier this year that the yuan was no longer undervalued. Given the substantial depreciation of the yen and the euro against the dollar, China had acquired a substantial currency disadvantage, one that the action of the past two days only partially reverses.

In many ways, then, China’s currency devaluation was justifiable—and, from a Chinese perspective, even necessary—for nongrowth reasons. Most likely, it wasn’t a deliberate currency war move.

Potentially big downsides . . .

Another Asian crisis? Regardless of China’s reasons, it now presents every other country with a decision: how to respond? As the largest economy (and a relatively closed one with already substantial currency appreciation), the U.S. will be least affected. But other countries have suddenly become less competitive against China and stand to suffer. Second-order effects include the strengthening of the U.S. dollar against other countries that are ill-equipped for it. Something like the Asian crisis of the late 1990s seems like a possibility, although not a certainty. 

We will see.

Can the PBOC step back? I’m also wondering whether Beijing is really prepared to accept a market-based currency. As we recently saw with the stock markets there, accepting the upside also requires accepting the downside.

According to reports, the People’s Bank of China intervened in the currency markets at the end of the day to limit the downward move, indicating that the government may be unwilling to accept a large depreciation of the yuan. If so, we might well see traders attempting to force the yuan further down and the PBOC fighting back, which would set the stage for even more uncertainty. If it happens, that could end up being the real problem.

Those are some of the potential downsides, and they could be big ones. This is the story that markets are currently reacting to. So far, at least, they’re doing so in a rational way.

But also possible benefits

On the other hand, the potential upside of China’s action has gotten very little attention. By essentially ending the peg to the U.S. dollar, the PBOC now has more flexibility in terms of cutting interest rates, which it can (and probably should) do to address weak Chinese growth. A cheaper yuan should also help restart Chinese growth, which would be good for the world as a whole in many ways.

The risks are real, but so are the potential benefits. China made its decision, as every country does, based on its own interests. In this case, however, no one benefits from slow Chinese growth, and everyone could benefit from faster growth. Despite short-term market reactions, this could end up being a positive over time.

Just something to keep in mind as the markets flash red.

Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.