/ 13 August 2015

Caught between a ¥ and a hard $

Markets were sent into a panic when China devalued its currency this week
Markets were sent into a panic when China devalued its currency this week

“Cross the river by feeling the stones” was the metaphor famously delivered by statesman and revolutionary Deng Xiaoping in describing how China would approach economic reform in 1978.

But as tough conditions befall the world’s second-largest economy, it has taken drastic emergency measures to stem the flow – the latest being the devaluation of its currency three times this week.

On Tuesday China devalued the yuan by 1.9% and, despite assurances that they did not signal further devaluation, the government further devalued the currency by 1.6% the next day and by 1.1% on Thursday. Although economists suggest this unusual monetary policy move is probably a positive one, many markets globally responded negatively.

In a press conference on Thursday, the People’s Bank of China said it wanted to move toward a more market-determined exchange rate (which had been pegged for four months). The bank said there was no basis for continued depreciation and said it would step in to control large fluctuations if need be.

On Wednesday, the MSCI Emerging Markets Index plummeted to its lowest point in four years. Global stock indices, such as the Dow Jones Industrial Average, the Nasdaq Composite, the FTSE 100 and the Hang Seng, declined on Tuesday and Wednesday. The Shanghai Composite Index did not decline but experienced upticks in performance over the same period.

Even weaker rand
On Wednesday South Africa’s JSE All Share Index closed 3.16% lower and the rand, already at 14-year lows, weakened, reached R12.87.

South Africa, along with other emerging markets, is now in the crosshairs of a weakening yuan and a strong dollar. The latter is expected to strengthen further once expected rate increases by the United States Federal Reserve begin. Prior to this, China’s decline was already a prominent global issue that affected emerging markets such as South Africa.

Lars Christensen, Copenhagen-based independent economist and founder of Markets and Money Advisory, said that, had China signalled on Tuesday that it wanted to ease monetary policy, there would probably have been a rally across markets. “But the sudden move sends a signal that things are worse in China than expected, or than what official numbers are saying,” he said.

Floating exchange rates, however, have been the norm in many countries since the 1990s and a move in this direction was the right step for China, he said.

Its move to a consumer economy means it can no longer control demand and supply components as it had in an industrial economy. The devaluation shows a focus on trying to fix exports, said Stanlib chief economist Kevin Lings, who added that the initial devaluation of 2% was “incredibly modest” because some currencies move that much on any given day. “It signals intent from authorities to boost growth. On the face of it, it suggests a good a thing.”

Think twice
A weaker yuan could make the US Federal Reserve think twice about raising interest rates, the speculation over which has already seen investment removed from emerging economies and placed back into the US.

Lings said the move had alerted one to the prevailing scenario: the biggest loser in the face of continued devaluation of the yuan will be the US because the dollar will continue to be relatively strong, hurting its exports. The weaker yuan means lower import prices for the US.

“What the Chinese currency weakness introduces now is more fears of deflation, and it says to the US it may well find itself importing more deflation,” said Lings.

“It is not good news for them, and maybe the Federal Reserve will have to hold back on rate hikes and see how this plays out.”

Christensen said the downside, currency-wise, is for the Asian countries directly competing with China, such as Korea, Taiwan and Vietnam. Nervousness in the market was creating fear of a currency war, with US trade sanctions as the worst-case scenario. “But I see that as rather unlikely,” he said.

Perpetual desire
Lings warned that the perpetual desire to devalue currency could undermine growth if everyone responded to devalued currency in a similar way. “You enter into a no-win situation when everyone tries to do the same thing.”

The G20 nations agreed some years ago that central banks would avoid entering currency wars. “It becomes self-defeating,” Lings said.

Christensen said there was a slight risk that South Africa’s exports to China could become less competitive. “But China needs more monetary stimulus to recover. Ultimately this would be positive, and help to stabilise export prices and export growth.”

Lings agreed the devaluation of Chinese currency could ultimately yield positive results for South Africa in the form of a commodities boost in the medium term. But, if it makes China more competitive, it could further undermine South Africa’s manufacturing base.

Nomura emerging markets analysts said in a note this week: “The rand for us remains at the nexus of Fed, China terms of trade and China devaluation themes in our region.”

It said there was scope for further yuan weakness, and with it more pressure on the rand-dollar rate.

Weaker fix rate
China’s weaker fix rate should have only a 0.34% effect on rand-dollar value – less than the metals price shock, which affects a significant portion of all exports to all countries (31% of total exports), whereas Chinese exports are a smaller share (about 9% of total).

“The market has been in two minds, first seeing the devaluation of yuan as a sign of weakness of the Chinese economy, then seeing it as supportive for Chinese growth and in turn global demand,” Nomura’s note said. “As such, the rand-dollar exchange rate has whipsawed violently after weakening at the open.”

Lings described emerging markets as “going through an awkward phase” for reasons other than the normalisation of US interest rates. Another reason for outflows is the performance of emerging markets is disappointing and has not yielded the results expected in terms of growth and investment.

“Money has never been as cheap or as readily available. Emerging markets could have used it better. So there is some natural aversion to them for this reason, too, as investors are not rewarded for the risk they are taking,” he said.

Additionally, commodity prices coming off sharply created an investor aversion to commodity currencies.

More pronounced
The issues faced by emerging markets are more pronounced in countries with current account and fiscal account deficits, such as South Africa. “South Africa’s economic fundamentals have deteriorated but we are not about to be downgraded to sub-investment grade,” Lings said. “We are not as bad off as we perceive.”

Although South Africa and the globe were going through a normalisation phase, he said, once through this transition, it was expected that more stability would return.

Other emerging economies, such as Russia and Brazil, with repo rates of 11% and 14.25% respectively, are struggling with structural problems and hike interest rates to curb currency weakness at times when tightening of monetary policy is not warranted, according to Christensen.

He said the South African Reserve Bank was known for its “much more reasonable view”, given that the rand was generally allowed to fluctuate freely. He did note that the yuan’s devaluation was something the Reserve Bank would take into account.

The downturn in China is a prominent cause of the reduction in commodities prices, which have fallen significantly in recent months as demand dries up and over-supply persists in many cases. The bottoming-out of commodities prices has been felt worldwide, and it will be especially painful in South Africa, where about 10?000 jobs are to be lost in the mining industry following a spate of retrenchment notices.

Emergency meeting
Last week the minister of minerals resources called an emergency meeting and established a technical task team to find ways to stem the massive loss of jobs.

Many of the retrenchments will be in the steel manufacturing sector, where mills are unable to compete with cheap imports from China. The largest steel producer, ArcelorMittal South Africa, has requested the maximum import tariff be imposed on Chinese steel in an attempt to prop up the local industry. In the gold sector, wage negotiations continue but attitudes have hardened. Employers say they are unable to increase their offers in the current climate and unions insist they will not relax their demands in response to either ailing metal production or price downturns.

But gold remains a preferred store of value in times of currency weakness, and the nervousness the yuan devaluation has created in the market has helped the gold price to bounce back in recent days from $1?080 an ounce a week ago to $1?121 on Wednesday.

Domestic issues have also hampered South Africa’s economy. One prominent matter is the power shortage, which has manifested in load-shedding since the beginning of the year.