John Minnich: Hi, my name is John Minnich and I am joined today by Matt Bey and we are going to be discussing China’s devaluation of its currency over the course of the last couple of days. So, Matt, it seems like markets and also mainstream media reacted very strongly to the depreciation of the Chinese currency over the course of the last three or four days. However, it also seems that to some extent mainstream media is either overstating the significance of the devaluation or misidentifying what exactly makes this significant. When you look at mainstream media reports, most of them emphasize the impact this is going to have potentially on Chinese exports and that the motivation is to stimulate Chinese export growth. This comes after some pretty bad export numbers from China in July. But is there something else going on here? Is there another issue at play?
Matt Bey: Right, so I mean just using the word devaluation carries a lot of weight. You can make the argument as to whether this is even a devaluation. What has basically been happening for the past six to twelve months is that the yuan relative to what they have pegged the reference rate to has actually been a lot weaker than that, at least the spot markets by about 2 percent. The way the yuan typically trades is that China will set a certain reference level and then they will allow the spot market to fluctuate up or down 2 percent around that before the central bank will intervene and either push it up, push it down, depending on what has happened. So, for the last six to eight months, basically since you have seen a lot of quantitative easing in places like Japan, Europe and then bad economic data coming out of China is that it has been weakening in a sense by itself. And then they have actually had to prop it up most of the time. So, what has actually changed is that now they are taking that reference rate and they have just moved it to where the spot market was the previous day and they are saying hey going forward we are actually going to be just letting each reference rate each day to actually be more reflective of the previous day’s spot market.
John: And why do you think they did this?
Matt: So, this is a big part of the long-term strategy that China has been pursuing wherein they want to liberalize control on their currency, which is a kind of decade long process. So, if you go back to the mid-2000s, up until that point it was heavily pegged to the dollar. They loosened that peg to a certain degree but they have had all these controls, they have had this trading band, they have been loosening the trading band by making that 2 percent figure by making it go up by 1 percent to 2 percent and then now they are thinking about even increasing that ratio to 3 percent and the big shift that we saw on Tuesday was them also then saying hey whenever we set the reference rate we are going to make it more reflexive on the previous day, which is a substantial shift away from that policy. So now instead of closely tracking the dollar they might not as closely track the dollar going forward. Of course, the big question is how often are they actually going to intervene to keep it in, how long can they actually stick to this policy.
John: And I mean it also seems like the issue here is that this comes against the backdrop of a year in which the dollar has been gaining relative to other major global currencies, the Japanese Yen, uh —
Matt: And when you look at the trade exchange rate for China, China yes they export a ton to the United States but who are the biggest trading partners? It’s Korea, it’s Japan, and that’s the bulk of what they’re going and look at Japan, they have gone through this massive stimulus package that has devalued the yen significantly. So look at the currency weighted to the trade partners, the yuan is actually over the last year been stronger than the dollar has weighted their own trading. So there is that big aspect too. But we also have to put this into perspective: we are talking about a 2-3 percent devaluation compared to a 10-20 percent devaluation in other countries.
John: So, I guess I am thinking about the significance of the depreciation of the yuan over the next couple of days. There would be two main lines of inquiry. One would be looking at the impact it is going to have domestically on the Chinese economy and also how this fits into the Chinese government’s broader economic reform goals. The other one we will set aside for now would be the international impact: how is this going to shape the behavior of China’s major trade partners, Japan, Korea, the United States, the European Union? So on the domestic front it seems to me that at least up to now, and if we see the depreciation stay within the bounds of 5-7 percent over the course of the year, or over the course of several months then it seems to me that is not going to have much of an impact on Chinese export performance. Honestly there are a lot of other factors that are going to effect export performance in China. At the same time, we look at maybe we raise the question of how this could impact household consumption because understanding this and the relationship to the reform goals, we have the Chinese economy moving from what it has been for the past 20 or 30 years, which is an economy in many ways heavily dependent on low-cost exports, and trying to move from an low-cost export- and investment-led economy to one that is grounded in household consumption. So I think that this is a potential risk of devaluing the currency or the currency depreciation at this point is that this could actually raise costs for ordinary Chinese consumers and could impact China’s ability to realize these goals of shifting toward a consumption-based economy and then thinking then about how that plays out regionally as well.
Matt: The other thing that you have to kind of consider is that they are fighting against the perception of the export-oriented model. So that now as they actually do begin to weaken their currency for a number of reasons, part of them to help exporters out a little and then also the liberalization push in general, is that there is still a stigma attached to China that this is a currency war type thing so that they can undermine other exporters so that they can gain that. But it is not reflective of the entire shift that we see going on in China with all the other reforms toward consumption. When we look at the things that could impact other countries, while the export competitiveness is not an important thing for places such as Japan all these Southeast Asian countries that are competing with China. The other big impact that it is also going to reduce China’s buying power if they were to substantially reduce the value of the yuan and for a place like Japan that is actually probably even more important because as the United States and Europe have slowed down their economies in the past five years since the financial crisis who has actually been somewhat strong with the stimulus through a number of things it has been China. So you have seen Japan become even more intricately connected to the Chinese market by sending their stuff to China so this is a double-edged sword for them. We do have the Bank of Japan considering increasing their own stimulus package. This only plays into the possibility of them doing that even more going forward. And then obviously the one that everyone else is talking about is the United States Fed decision and this plays into that to a certain degree. The Fed has a different mandate entirely than just defending the U.S. dollar but at the same time this does play into their model to some degree and if anything it may not reverse a decision to increase interest rates that the Fed makes but it at least might make them want to take a wait and see approach to what China’s going to do with their currency over the next couple of weeks and maybe delay that decision from possibly December to November.
John: Well thank you very much, Matt. We will certainly be watching very closely to see how these incremental shifts play out in the long-term in terms of both China’s internal reform efforts but also the implications that this has for the behavior of other major regional and global economies in particular Japan in this case. That is all the time we have for today. If you would like more, please go to Stratfor.com.