China’s Currency and the Dollar-Debt Time Bomb
Investors may have a false sense of security that China is loath to devalue the yuan again
Investors betting China won’t take another run through the bull’s market shop ought to be careful.
Things are looking more settled than in August, when a surprise devaluation by China sent paroxysms through global markets. Stocks in developed countries have mostly recovered, even as investors contend with the likelihood the Federal Reserve will raise rates.
One possible reason for the calm is that investors may have reckoned that China, having backed off after witnessing the problems that it unleashed in August, is loath to repeat the experience. Indeed, the value of the yuan has been remarkably stable since the summer’s policy change.
But this may have only created a false sense of security among investors. A decision expected later this month from the International Monetary Fund on whether to include the yuan in its reserve currency basket may have China holding off on any sudden moves. Once that decision is made, China may feel freer to let the currency fall.
If so, it wouldn’t take much to unsettle markets again. This summer’s yuan devaluation was relatively minor, falling by just 3% versus the dollar over three days. Yet it set off fears of a series of competitive devaluations. Other currencies fell against the dollar, and commodity prices came under heavy pressure.
One reason that is such a concern: In recent years, there has been a marked increase in dollar-denominated lending outside the U.S., much of it coming through bond issuance rather than banks, and much of it destined for emerging-market borrowers. The Bank for International Settlements estimates that the amount of dollar-denominated credit extended to nonbanks outside the U.S. reached $9.7 trillion in the first quarter this year, from $5.3 trillion at the end of 2007.
For commodity producers straining under dollar debt loads, like Brazil, the pain can be acute. The MSCI Emerging Markets Index, which had already been under pressure this summer, fell by 13% in two weeks after China’s move. It has since gained back much of that lost ground.
So what happens next? The “X” factor is Chinese capital flows.
Part of the reason China blinked in August is that the move triggered a large outflow of cash. This is inherently destabilizing because it undermines the ability of China’s central bank to keep the financial system liquid. For years, China relied on inflows to boost money supply. When money is flowing out, banks starve for cash.
October data on foreign-exchange reserves showed a respite in outflows, with reserves rising for the first time in six months. Given the economy’s anemic state, that may be temporary, especially if the Fed proceeds to raise rates.
China’s stimulus measures have been mostly ineffectual. Pushed against the wall, allowing fresh devaluation could prove Beijing’s best option. That would make China’s goods more competitive in foreign markets, especially emerging ones. Eventually, outflows would subside if China lets the currency get cheap enough to attract capital back in.
So while investors are more sanguine about global risks now, markets may be sitting on a tinderbox. China’s currency path will determine whether a dollar-debt fuse is lit.