Chinese Finger Trap
WHAT DOES DEVALUATION OF THE YUAN MEAN FOR US?
The Chinese finger trap gag has been used for years to play jokes on unsuspecting kids and adults for years. It is a simple puzzle that traps the victim’s fingers in both ends of a cylinder made of woven bamboo. The harder you pull out on the trap, the tighter it gets. The way to get out of it is to relax and gently push inwards thereby loosening the trap and allowing escape. The Chinese Finger Trap is also a metaphor for a problem that can be overcome by relaxing. Maybe the markets should relax a bit on all the reaction to the Chinese government’s recent moves to weaken their currency.
A couple of things have happened in China the last few months that have had an impact on the stock markets around the world. The first was the bursting of the Chinese stock market bubble. Chinese stocks, especially smaller stocks had been on a tear somewhat similar to the internet bubble here in the U.S. in 1999. A lot of this was caused by the growing Chinese middle class jumping into the stock market at the urging of the Chinese government. People saw their neighbors making money in the stock market and more and more followed, introducing rampant speculation into the markets and often driving stock prices up dramatically without any fundamental reason. Prices and valuations become way too high and as markets usually do, they “correct” when things get out of whack.
The beginning of the sell-off in Chinese stocks was likely caused by their slowing economy. Since their currency, the Yuan, is loosely pegged to the U.S. Dollar (the People’s bank of China controls the currency each day by setting its value against the U.S. Dollar and only letting it trade in a small band above and below that level), and the U.S. Dollar has strengthened substantially the last several months, it has been harder for the Chinese to export goods around the world. This is due to the fact that when a country’s currency appreciates relative to other currencies around the world, the goods that they export become more expensive to other nations buying their goods, because it now takes more of the purchasing country’s currency to buy those products. This is what has been happening to large companies here in the U.S. that export around the globe. They are reporting reduced earnings due to the effect of the stronger dollar.
WHAT IS THE CHINESE GOVERNMENT DOING?
The Chinese government has been trying (mostly unsuccessfully) to stem the tide of the stock market decline by trying several things. They have been lending money to brokerage firms to buy stock, introduced additional fiscal stimulus by speeding up infrastructure spending, halted trading in many stocks to stop them from going down, and slashed interest rates. None of these moves have had that much success.
This leads us to the second event in China recently that has caused consternation in the markets, the devaluation of the Yuan. As mentioned above, since the Yuan has been loosely pegged to the U.S. Dollar the last few years, the appreciation in the dollar has resulted in appreciation of the Yuan, and the resulting decrease in exports in China, has likely caused their economy to slow substantially. Thus, the People’s bank of China loosened the trading bands on the Yuan to move towards a “more market based exchange rate”. Now that a truer market for the Yuan is in place, the market has continued to drag the currency lower, resulting in the devaluation. However, China still controls how far the currency trades from the U.S. Dollar, so that one can argue that, yes they are devaluing their currency but if they weren’t controlling the trading levels it would actually be weaker than it is. So, another side of this story could be argued that China is keeping the Yuan stronger than it should be. Interesting.
However, you would have to expect that the government has seen a substantial slowdown to resort to devaluing their currency, and risk ticking off their trading partners such as the U.S. Now that the Chinese are devaluing their currency other countries that are not already doing this may jump into the fray as well and do things to try to weaken their currencies as well. But, the total devaluation of the Yuan so far has only been about 5% or so versus the dollar, so we are not talking real large amounts just yet. Maybe the markets are overreacting a bit to this news and in the last couple of days, things have settled down.
So what might the effects be here in the U.S. of China devaluing the Yuan?
- Cheaper imports, more expensive exports. Those Chinese goods you buy at Wal-Mart should get a bit cheaper.
- Other countries may respond by de-valuing or trying to weaken their currencies as well.
- It may cause Janet Yellen and the Federal Reserve to hold off on raising short term interest rates.
- Job losses in the U.S. due to falling earnings of large companies is a possibility.
- Cheaper gas and lower commodity prices if there is less demand from China.
- Falling stock markets if more countries start to experience slowdowns in their economies.
Yet another angle on why China is trying to let the market have more sway in dictating where their currency trades could be this:
Right now the U.S. economy still appears to be in good shape and continues to plug along. True, it is a somewhat muted economy, but it does continue to grow, nonetheless. However, we will want to watch what continues to happen in China, and if their economy does continue to weaken this could have effects on the rest of the world. But, in the meantime a lot of this consternation may all be overblown and markets should just R E L A X.