Contributed by: Nicholas Boguth
The biggest Yuan devaluation in over 20 years shook up the markets late last year and has been a recent source of uncertainty for investors. What exactly happened? And why would China want to devalue their currency?
Why peg one currency to another?
Well, many developing countries fix the exchange value of their currencies to one of a more stable economy’s in order to stabilize their currency exchange rate fluctuations and better control domestic inflation. The U.S. Dollar is a preferred target for other countries because it has a highly liquid government bond market and a relatively stable economy. In fact, Saudi Arabia, Venezuela, and Egypt, among others are all currently pegged to the U.S. Dollar.
Why would China discontinue its Yuan peg to the U.S. Dollar?
The Yuan has been tied to the U.S. Dollar since 1994, but China has had a deep economic slowdown while the US economy has been going through an expansion in recent years. Monetary authorities typically take opposite actions in these two different phases of a business cycle. As we have seen, the Fed has started to raise interest rates, which usually leads to a currency appreciating, and stimulates the economy less. The People’s Bank of China wants to stimulate the economy more during their contraction, so staying tied to the U.S. Dollar would be contradictory. If the dollar rose while the Yuan was pegged to it, then the Yuan would rise too.
A more expensive Yuan puts pressure on exporters that are a large part of China’s GDP. During China’s economic slowdown, their exports have been hurt. By devaluing their currency and allowing it to diverge from the U.S. Dollar, China is saying that it wants to focus effort on supporting exporters because a cheaper Yuan makes Chinese exports more attractive to foreign countries. This is a stimulus meant to boost economic growth.
What could go wrong?
While a cheaper currency is good for exporters and can help boost domestic economic growth, there is downside as well. A major risk of devaluing a currency is capital outflow. If the value of a currency drops, investors may move themselves or their money out of the country and into another that has a stronger currency.
China is not completely abandoning a peg though. Rather than tying their currency to the U.S. Dollar alone, they are tying it to a basket of currencies. This will allow it to stray from the U.S. Dollar, but will not allow the exchange rate to float independently and risk a larger amount of currency volatility.
Nicholas Boguth is an Investment Research Associate at Center for Financial Planning, Inc.
This material is being provided for information purposes only and is not acomplete description, nor is it a recommendation. Any opinions are those of Nicholas Boguth and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete.