Markets across the globe have fallen on the back of mounting fears over the health of the Chinese economy, with the authorities allowing the renminbi to devalue adding further to the woes as it sparked fears of a new currency war.
Concerns that China is heading for a so-called hard landing have been present in the market for some years, with added worries over the country’s ability to transition its economy from an investment-led model to a consumption-driven one. The latest Bank of America Merrill Lynch Global Fund Manager Survey shows that a Chinese recession is now the biggest concern among asset allocators.
More recently, mainland stocks markets have tumbled strongly over the past few months following the huge gains made on the back of the Shanghai-Hong Kong Stock Connect programme and moves by the central bank to stimulate the economy.
Price performance of indices since 1 Jun 2014
Source: FE Analytics
Shockwaves were sent through global markets last week when the People’s Bank of China devalued the official renminbi reference rate against the dollar in an attempt to increase exports and move closer to becoming a reserve currency.
The move prompted a strong reaction from commentators as well. Société Générale economist Albert Edwards said in a note: "Make no mistake, this is the start of something big, something ugly. Investors should prepare for a tidal wave of deflation from Asia.”
Edwards also predicted “a financial market rout every bit as large as 2008” when the effects of this deflation hit major economies such as the US, damaging their corporate profits and threatening to plunge them into recession.
The central bank’s action will no doubt prompt anger in the US, which has long maintained that the renminbi is already undervalued and harming its own exports. If other Asian nations follow suit this would add to the US’ trade deficit and lift the potential for a global currency war.
James Klempster, portfolio manager at Momentum Global Investment Management, argues on the other hand that talk of a currency war seems to be premature given the fact that the currency only went down by around 3 per cent.
“Firstly, while important symbolically, the size of the move is relatively small. The yuan had been managed up consistently by 33 per cent over ten years, whereas the fall of circa 3 per cent over a few days is sharp but not large,” he said.
“Furthermore, China’s economy is less export led than many believe. Over a 10-year period to 2014, Chinese GDP saw a 3 per cent reduction in net exports from annual growth whereas investment grew – contributing an average of more than 50 per cent each year. This sounds rather more like a society enriched (and therefore importing more) by government largesse rather than exports.”
Performance of renminbi vs dollar over 3yrs
Source: FE Analytics
Klempster also suggests that the renminbi devaluation was carried out to make imports into China less attractive. This would support domestic demand and would be in-line with the overarching strategy of building the economy more around consumption.
In addition, the move could have even been carried out in response to fears of deflation and the effect this would have on its debts denominated in its own currency.
“One possible reason why China may be devaluing, which has received less coverage than the currency-war thesis, is that China is becoming increasingly worried about deflation. While their currency was pegged to the (strong) US dollar they had seen substantial falls in a number of key input costs – such as energy – which are denominated in US dollars,” he explained.
“Over $1.6trn in foreign currencies has been borrowed by various Chinese bodies, and while devaluation of the yuan makes serving this debt more difficult at least an inflationary environment would ensure that the real value of outstanding local debt does not also increase. Indeed, China’s domestic debt has increased materially during its investment boom and while it still retains substantial reserves, China’s recent reluctance to use them may be driven by longer term economic concerns on the part of the government.”
John Bilton, global head of multi-asset strategy at JP Morgan Asset Management, also believes that China’s move is part of its long-term economy rebalancing plan, not the opening salvo of a currency war.
He points out that market liberalisation efforts – including moves towards floating the currency – are “fundamental” if the economy is to base itself off consumption and productivity rather than exports and capital expenditure.
While he sees the devaluation as disinflationary and the renminbi’s fall is significant in the context of its own trading band, it is “tiny” compared with the recent price action of other currencies such as the euro, yen and Australian dollar. 
“If this was China is instigating a currency war, they have brought a peashooter up against a canon – which is hardly the playbook we’d expect. Our belief is that we’ve simply seen another step towards China’s goal of gradual liberalisation of their financial markets,” he added.
Not everyone is sanguine about the news, however. Guy Stephens (pictured), managing director at Rowan Dartington Signature, says the renminbi devaluation could be “the new worry for us to contend with” now that the Greek debt crisis has paused for breath.
“We are all aware of the challenges Chinese domestic investors have faced in the last few months as their equity market has gyrated around and the central authorities have attempted to control the volatility. Devaluing the currency is supportive of that goal and sure enough the Chinese market did benefit. However, the bigger external worry is what it says about the state of the Chinese economy as devaluing is a significant action to take and is likely to be driven by a need to stabilise the equity market,” he said.
“Whilst the opaqueness of the Chinese GDP numbers is well known, it doesn’t help when the currency is devalued. Indeed, this is surely a step that no government would choose to make when they are trying to rebalance the economy in favour of domestic consumption as it makes the purchasing power of the Chinese consumer weaker. It also sends a message to the west that all may not be well under the bonnet despite all the polishing that goes on.”
For UK investors, this means the FTSE 100 could suffer if the mining and energy heavyweights that dominate – but are directly connected to the China story – continue to fall, especially as a weak China combines with a lower oil price and stronger dollar.
Similar effects could be seen in other international markets, Stephens says, with international-facing businesses and sectors possibly heading for a tougher time than small, more domestic plays.
“It used to be said that when America sneezes the rest of the world catches a cold,” he added. “With China adjusting its currency, for whatever reason, all eyes will be on future economic data releases to see whether there is a dose of Asian flu ahead.”
