Yuan is China’s currency but US Federal Reserve’s problem
What may be changing is official willingness to deploy massive foreign reserves to prop up currency
Remember how China and the weakening yuan was a problem for the US Federal Reserve and then, just as suddenly, wasn’t? Well, it is again.
The yuan looks set to continue to weaken, which will not only put pressure on other emerging and Asian economies but also act as an additional deflationary force in a world with little inflation to spare.
That may undermine inflation in the United States, impairing the Fed’s ability to raise interest rates. Riskier assets like equities will not enjoy a world in which the Fed is unable to do more than raise rates once or twice before it is forced to think again about loosening.
US stocks fell sharply again on Thursday, the S&P 500 falling 2.4 per cent, after China allowed the yuan to fall by the most in five months.
Chinese owners of yuan have good reason to want out and China itself has good reason to want to allow the yuan to weaken, as well as increasingly limited alternatives. Taken together, that makes a considerably weaker yuan the prime risk for the global economy and markets in coming months.
The Fed delayed a widely expected rate increase in September over “global risks”, widely acknowledged as being because Chinese woes looked capable of both depressing net exports and sending the US dollar higher.
The Fed duly tightened in December, after the International Monetary Fund included the yuan in its preferred basket of reserve currencies, a decision which China did not want to muddy with contentious devaluations.
Fed officials have been at pains recently to show they are relaxed about China. Cleveland Fed president Loretta Mester said on Monday they'd “built in a weakening path” for China, echoing similarly reassuring comments from John Williams of the San Francisco Fed.
Yet a look at the minutes of the rate-increasing December meeting shows a bit more concern. Both the strong US dollar and slow economic growth overseas were cited as potential restraints to future increases as well as “significant concern about still-low readings on actual inflation”.
Fed chairwoman Janet Yellen was able to build unanimity for the decision, but fissures below the surface must remain, notably concerns expressed earlier by Federal Reserve Board members Lael Brainard and Daniel Tarullo.
China has suffered two spectacular down days on its stock market this week, having twice seen trading suspended after a 7 per cent fall in the benchmark CSI 300 Index – on Thursday just minutes into the trading day.
Think of China’s stock market woes as a side effect of the main risks to global growth, rather than a cause. Chinese investors want out of Chinese stocks for many of the same reasons they want out of the yuan.
Mainland Chinese investors want to lighten up on yuan positions for two main reasons: they suspect it has farther to fall and they have good reasons of their own to want to move some money offshore. A crackdown in China on corruption has coincided with the economic slowdown to make yuan owners worried for their future fairly price insensitive. The great thing is to get some money offshore, perhaps to offset US dollar debts but also as a hedge against confiscation or worse.
The tactics taken by China in response to last year’s stock market blow-off only worsened matters, with arrests and public confessions by supposed market manipulators giving many who weren’t good reason to want out. All of these factors are self-reinforcing. Repression sows the desire for diversification and a falling yuan reinforces the benefits of holding other currencies.
What may be changing is official willingness to deploy massive foreign reserves in order to prop up the yuan. Data released on Thursday showed that foreign exchange reserves fell by a record US$108 billion last month, taking the bill for 2015 to US$513 billion. That still leaves US$3.33 trillion of reserves, but few central banks like to see their monthly burn rate as high as it was for China in December.
As for the Fed, at this point it has little choice but to sit back and wait. China may do any number of things, but most of what seems likely would lead to further gains in the US dollar, both against the yuan and other regional and emerging market currencies.
Of some comfort is the relative strength of the US domestically focused consumer economy, and continued gains in the job market.
The big risk for markets remains and it isn’t how they will react to further losses in China. It is how they would react to a Fed which, having begun to tighten, is forced to soon call a halt.