ALMOST however China chooses to play its management of the yuan, emerging markets are going to feel negative fallout.
The yuan slid for a third straight day on Thursday despite protestations from the People’s Bank of China that there was no reason for it to fall further.
Starting with an initial depreciation of 2% and carrying on amidst conflicting talk from authorities about markets setting prices while China intervened, the situation is far from clear.
If China’s primary intention is to win its exporters a more competitive position then this looks to be the start of an extended bout of weakness for the yuan.
If, instead, China is trying to lay the groundwork for a more open financial system without setting off a deluge of capital flight then it will keep a tighter hold on the currency’s movement.
Neither of those alternatives is particularly appetizing for emerging markets.
“Even before August 11, 2015, there were plenty of economic reasons for Asian and other emerging market currencies to depreciate further.
Now a prospective depreciation in the yuan will add to this trend,” Stephen Jen and Joana Freire of hedge fund SLJ Macro Partners wrote to clients.
Ahead of the shock devaluation, emerging markets, particularly in Asia, were being buffeted by a complex set of forces.
Firstly, China’s rate of economic growth has slowed rapidly, dampening demand for raw materials from abroad.
At the same time, China’s trade surplus ballooned, implying that even at the earlier richer levels for the yuan it was hardly being outcompeted on trade.
Also at the same time, perhaps more importantly, financial markets were rapidly coming to the conclusion that U.S. interest rates will soon rise. That’s deadly for emerging markets, not simply because many depend on flows of capital from abroad to finance themselves, but also because, as investments at the riskier end of the spectrum, emerging market instruments respond more violently to changes in the global price of money.
It’s no surprise then that emerging market currencies are at a 15-year low and that emerging market equities are in a bear market. The MSCI Emerging Market index is down just a shade less than 20% since April.
A falling yuan will both impair Chinese purchasing power for imports, be they raw materials or consumer goods, and make Chinese products that much more competitive elsewhere, hurting exporters everywhere from Brazil to Thailand.
Commodity prices have tracked lower since the initial devaluation, having already been firmly established in bear territory.
So, if China has more of the same planned, then emerging markets will suffer keenly. The obvious temptation elsewhere would be to engage in their own round of beggar-thy-neighbor currency devaluations.
Even if this doesn’t happen, China, by lowering the value of the yuan, albeit in the direction it would travel if not manipulated, is exporting deflation.
That deflation will hurt the global economy, but perhaps particularly emerging markets, especially those with substantial dollar-denominated liabilities.
Conditions might be slightly better if China elects to keep the yuan roughly where it is, but unless they do so because capital no longer wants out of China it won’t be of much help to emerging markets. The devaluation was likely taken at least in part as a reaction to more than a year of strong capital flows out of China, as Chinese invest abroad amid a weakening domestic economy and seek to diversify against the possibility of confiscation at home.
China will be mindful about turning a steady outflow of capital into a gusher, something it can do if it creates the impression that the yuan will weaken sharply.
This implies that China will continue to make slow progress in opening financial markets, perhaps hoping for better times in which to do it later.
If China elects to hold the line, more or less, on the yuan, it is going to need to use some of its ample foreign currency reserves to supply the dollars to make that possible.
The problem, however, for emerging markets, is that this flow of dollars out of China will be financed in part by selling or maturing Treasuries owned by the PBOC.
Buy Treasuries, which play a disproportionate role in setting global financing conditions, and you make the world a friendlier place for borrowers.
Sell them, as China will if it keeps control over the yuan, and you do the reverse. Interest rates, all being equal, will rise, and emerging markets will feel the worst of that, as they always do.
Emerging markets, already hard hit, will not have an easy run to the end of the year.