Markets Fall As China Devalues Currency

Markets Fall As China Devalues Currency.

In a surprise move China has devalued its currency by just under 2%. The YUAN exchange rate is controlled by the state owned People's Bank of China allowing the Chinese government to effectively manipulate the costs of its goods and services exports across the globe. Given the dramatic fall in China's stock market, the Shanghai Composite, over the last few weeks due to a decline in exports of around 9% per annum, the Chinese government has taken action.

The currency devaluation will mean that Chinese goods are cheaper across the globe and whilst the Chinese government described the devaluation as a "one-off depreciation" and a move towards China's currency operating closer to true market forces, we see the risk of a potential currency war. For many years the West has demanded of China to let its currency float freely in the markets so that it finds its true value but the Chinese government have not done this, they have set exchange rates against the world's major currencies to enable them to control export income. Thus artificially securing higher income flows into China than would have occurred if the Chinese currency were allowed to float freely in the markets.

The fall in Chinese exports due to reduced demand in the US, Europe and other areas of the Far East in addition to increased labour costs in China has prompted this devaluation.

Markets did not react positively to this because it means Chinese goods will become cheaper compared to Western produced goods meaning lower profitability for Western companies. In addition, it also means that the costs to import raw materials and power into China will increase, again driving up prices for the same raw materials and power for Western companies meaning profits will fall.

Comment

China is already the world's second-largest economy and we suggest this is an aggressive move to protect that position and indeed increase demand for Chinese goods and services. It will also increase the costs of Western goods in China which could damage both UK, US and European manufacturing hence the stock market falls seen today. As we said above this could even trigger a silent exchange rate war as Western countries move to protect their own manufacturing base.