Global markets initially cheered China’s weekend announced that they would allow flexibility in the exchange rate of the Yuan (or renminbi), but ultimately concluded that the move is too small and incremental to have significant meaning. 

There is little doubt the move was politically motivated, but it’s also likely China realized that pegging its currency to the U.S. dollar no longer serves the best interest of the country, especially since the dollar peg effectively yields control over monetary policy to the Federal Reserve.  From my perspective, the flexible exchange rate signals that Chinese policymakers are more confident in their ability to transform from a low value-added export economy to one that’s got domestic factors at the core.

In the very near-term, the Yuan appreciation will progress in a stop-and-go manner, and it is unrealistic to expect any large moves.  Still, the People’s Bank of China (PBOC) did specifically say the flexibility in the Yuan valuation can reduce their economy’s “overreliance on exports,” indicating an expectation for the Yuan to appreciate.  Most estimates I’m seeing have the Yuan appreciating somewhere between 8% 10% over the next year against the dollar.

Politically, the impact of China’s policy shift is meaningful since protectionist legislation from other G-20 economies will likely be put on hold.  The risk and potential damage of punitive tariffs imposed on Chinese exports is far greater than a controlled currency move – make no mistake, China is controlling this currency move rather than letting the rate reflect market fundamentals.

Economically, China’s policy shift is more likely to cause some global economic rebalancing rather than enhance global economic growth. 

The most prevalent change is the shift in deflationary pressures among key economies of the world.  In very simple terms, this means the U.S. will have more exports and China will have more domestic consumption.  This is because a rising Yuan boosts Chinese consumers’ purchasing power, meaning they will buy more exported goods.  Meanwhile, U.S. consumers will pay more for goods as the Yuan rises against the dollar and, thus the U.S. will increase their exports.

Increased inflation pressures in the U.S. and elsewhere is another possible implication of a stronger Yuan, although the impact should not be substantial.  According to Liz Sonders of Charles Schwab, total import goods are only 18% of the U.S. CPI basket, and labor generally only accounts for 5% of the retail price of consumer electronics.  Inflationary pressures in China, on the other hand, may lessen if a stronger Yuan can reduce excess liquidity creation and prevent property speculation. 

Finally, moving away from a fixed exchange rate lessens the boom-bust risk in the Chinese economy.  Chinese authorities have tried to cool their red-hot economy in recent quarters and allowing the Yuan to appreciate should help their efforts.  This is important because a bust in China spells trouble for the rest of the global economy.

Peter Lazaroff, Investment Analyst

www.acrinv.com