China devaluation could be game changer for forex markets
China's move to devalue the RMB by 1.9% on Tuesday and lowering the mid-point rate by 1.6% to USD/RMB 6.3306 on Wednesday could be a prelude to a full blown currency war and may keep monetary policy lax around the world for longer – even seeing a delay in the timing of the first US rate rise in nearly a decade.
China is the world's number two economy and its actions therefore have a big impact on the global markets. It's latest move saw Asian currencies plunge along with AUD and NZD with JPY also falling, but then recovering as risk-off sentiment took hold as it is a safe haven currency.
The People's Bank of China (PBoC) was quick to reassure that this is just a one-off adjustment. The PBoC is seeking to let market forces play a greater role in setting the RMB exchange rate. This echoes China's current policies to liberalise its economy, the financial services sector and to allow a greater role for market forces in allocating resources.
It also wants the RMB to be included in the IMF's Special Drawing Rights, which are a kind of international reserve asset designed to balance liabilities between countries. It is however hardly used. Nonetheless, China wants RMB to be one of currencies included in the SDR basket, so it's currency can be recognised as a global reserve currency. Inclusion would involve China having to liberalise its currency and move towards being more free floating.
AUDUSD – more losses expected on China proxy trade
RMB looks set to weaken further
Much of the media attention from the move has focused on China devaluing to boost its economy – recent data shows exports fell some 8% in July. However, it will take more than a 1.9% fall to refire China's exports. Given the rise of the RMB in recent years, to have any big impact on exports, the devaluation would have to be in the order of 10-20%.
Whatever the real reason behind China's move it is highly likely to have the following impacts:
1/ Cheaper Chinese exports will fuel deflation adding to plunges in commodity prices.
2/ The deflationary impact will see monetary policy around the world stay lose for longer – and may even delay a US rate rise, which will cap the USD's rally.
3/ As China liberalises its exchange rate, the RMB is likely to fall further given that it has been digging into forex reserves to maintain the earlier strength.
With the RMB looking set to weaken further – probably via gradual managed declines – other Asian currencies, including AUD and NZD are likely to follow in its wake versus USD, EUR and GBP.
It's unlikely that China wants a full out currency war – after all it wants to turn the RMB into a global reserve currency and rebalance towards a consumer driven economy. As a major exporter it would also be a significant loser if a currency war degenerated into a trade war.
Nonetheless, there's a risk that a currency war could be triggered by accident as the RMB adjusts to the reality of China's slowing if not increasingly troubled economy, which would unleash more volatility in global markets.
By Justin Pugsley, Markets Analyst, MahiFX