Duncan Lawrie Online ▼

Posted on: 08 September 2015

The plunge in China's stock market stole headlines in August. The Chinese authorities' seemingly misjudged attempts to protect Chinese equities from a bear market made for some alarming articles in the press, with Chinese hedge fund managers allegedly having 'disappeared' and sell-side analysts being 'discouraged' from making sell recommendations.1

However, whilst embarrassing and at times alarming, the events in the stock market are something of a colourful sideshow, as it in fact accounts for a relatively low proportion of Chinese household wealth. The main topic of interest is the devaluation of the yuan versus the dollar because of its implications for the global economy.

China's currency peg2 to the dollar has been controversial for some years. It used to be considered by the US as being set too low, as it made Chinese goods much cheaper and more competitive than they otherwise would be. More recently, as the Chinese economy has slowed down to accommodate a shift in its economic model away from capital investment and towards consumption, it seems clear that the peg is too high. Chinese manufacturing has been uncompetitive and the cost of maintaining the peg has kept monetary policy too tight.

The devaluation should benefit the Chinese economy by allowing interest rates to be cut and making exports more competitive. However, the 3.3% depreciation that has occurred so far will have little impact on exports, so further devaluations are likely.

The consequences for the rest of the world are complex and multifaceted. First, the devaluation should be deflationary for the West and beneficial for the western consumer, as cheaper Chinese goods become available in the shops. Second, it should mean that interest rates will be lower than they otherwise would be. Third, real assets in the West, such as property and infrastructure, may benefit from the capital that is likely to leave China. Finally, emerging markets and commodities are likely to see further selling pressure.

There is considerable uncertainty as to how events might play out and it will largely depend on how other players respond. The Chinese devaluation is a challenge for Japan and Europe, who have deliberately weakened their own currencies to stimulate inflation and economic growth. If they respond aggressively with further quantitative easing measures, a dangerous currency war could emerge which would depress global trade.

The complexity of these events and the wide range of possible outcomes have led us to be cautious. While we could see global equities rally from their oversold levels, these issues are likely to mean that volatility is here to stay. We reduced our equity exposure last year because we felt that the six-year bull market in stocks was becoming stale and that trouble might be ahead. We believe this view still holds water today.
 

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All data has been compiled by Duncan Lawrie from sources believed to be reliable. Full details of sources are available on request.
Information provided in the above articles and any opinions expressed are for general use only. You should always take specific advice to suit your personal circumstances before taking any action. Errors and omissions excepted.
The value of investments and income generated may fall as well as rise, and investors may not get back the amount invested. Past performance is not a reliable indicator of future results.

1. http://www.ft.com/cms/s/0/960a7ada-514a-11e5-b029-b9d50a74fd14.html?siteedition=uk#axzz3kV0lJ6UG    
   http://www.ft.com/cms/s/0/9d41edec-5050-11e5-8642-453585f2cfcd.html#axzz3l2Fg3L7T
   http://www.ft.com/cms/s/0/082499ca-2658-11e5-9c4e-a775d2b173ca.html#axzz3j4wy2MpB

2. A type of exchange rate regime where a currency's value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold. Source: Wikipedia

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