Currency markets are extremely difficult to grasp and most people’s experience with foreign currency is limited to travel. These experiences generally involve moments where someone realizes they just paid roughly six dollars for a Diet Coke at the Eiffel Tower or that they can buy a substantial amount of beer for the equivalent of a dollar in China. This week the news that China had devalued its currency the renminbi or (RMB) by two percent was headline financial news and drove market volatility around the world. Two percent is not a lot of anything so why does this matter so much? On the surface, having a strong economy and a strong currency should be the goal of every country. However, in times of economic weakness central governments only have a few leavers to pull to stimulate economic growth.
One of the obvious and favorite methods is to stimulate economic growth to lower interest rates. This has been done in the United States since the financial crisis and numerous other governments around the world have used this play from the economic rescue playbook. One of the other techniques is to have a weak currency. Having a weaker currency gives a country a potentially large economic tailwind because it makes goods that are exported from the country with a weak currency relatively less expensive when exported to a country with a stronger country. To use a beer analogy, Tsingtao beer from China is normally 8 dollars a six pack at the supermarket and Stella Artois from Belgium is also around the same price. If China devalues its currency, the beer distributor can then buy Tsingtao for a discount because the U.S. dollar buys more Chinese RMB and therefore more Tsingtao. The relative price of the Tsingtao is now less than the Stella Artois and consumers will substitute the less expensive good for the more expensive good. It can be broken down to an ECON 101 scenario of supply and demand and consumer preference. If you then multiply this effect by a billions of dollars of exports from China or another country devaluing its currency it becomes impactful.
Officially, most countries profess to maintain a strong currency policy as that is often associated with a strong economy. Zhang Xiaohui, an assistant governor of the central bank of China, was quoted in The New York Times stating that the RMB is a strong currency and there was "no basis for the continued depreciation of the renminbi." The decision to depreciate the RMB was characterized by the Chinese government as a move to make the currency more market-oriented.
The fear by investors is that this is a sign that China is struggling to keep its economy growing. While China's last GDP growth number was 7 percent year-over-year, there have been worries about the Chinese economy slowing and that the actual growth rate was materially lower than what was “officially” reported. Data has been mixed relative to economic growth in China with worries about a property market bubble and economic indicators such as auto sales being very weak.
Our Takeaways for the Week
- Currency devaluation can be positively impactful to economic growth as it creates a tailwind for an export economy
- The signal that the markets took from the Chinese currency devaluation this week was that the growth in China is possibly weaker than the government was officially reporting