13th October 2015
Alan Cauberghs, senior investment director for fixed income at Schroders looks at whether or not investors should be concerned about the currency tactics of global powers…
The summer months of 2015, and August in particular, were unsettling for investors. The sharp sell-off in equity markets and volatility in bond markets were made all the more unnerving by what appeared to be very mixed messages from different economic regions.
On the one hand, we continue to see strengthening economic data from the US and the UK, and a stable picture of the eurozone’s progress. On the other hand we have the Chinese government and People’s Bank of China (PBoC) making strident changes to monetary policy to support the slowing economy. All while the oil price languishes around its lowest ebb in over six years. The addition of alarming headlines alluding to ‘currency wars’ doesn’t help, but this at least is one story we think investors can remain relatively sanguine about.
Looks like a currency war, sounds like a currency war … but not a currency war
In simple terms, a currency war is an intentional devaluation or depreciation in the value of an economy’s domestic currency. The phrase refers to action from a country’s central bank; generally reducing the value of its currency in order to gain competitiveness and increase exports. On this basis, it could be argued that the action announced by the PBoC in August does not represent a currency war movement at all.
Since 1994, China has pegged its currency to the US dollar, barring a three year gap from 2005 to 2008, in which the renminbi was allowed to appreciate. In August this year, the PBoC brought the reference rate in line with the market rate. The move may indeed have supported the economy, only time will tell. In our view, the decision was more substantially motivated by China’s desire to turn the renmimbi into a reserve currency. One of the International Monetary Fund’s (IMF) criteria to allow this is for the market to set the exchange rate, not the PBoC.
This alone would begin to refute the idea that the PBoC’s decision was purely a tactic in a currency war. Furthermore, China’s multi-decade transition from an export and manufacturing led economy to one driven primarily by the service sector and domestic demand will be a drawn-out process; one which will likely cause further fluctuations in the renminbi. The Chinese central bank has suggested that the moves were introduced to smooth the inevitable currency volatility on that road.
Looking at some other economies within the ‘BRIC’ group – which comprises Brazil, Russia, India and China – currency depreciation in 2015 has been dramatic. The Brazilian real and Russian rouble have seen stark depreciations of their domestic currencies in 2015, but this is due to economic vulnerability, not central bank involvement.
So what does this all mean for investors?
Currency, and relative currency strength, is of course still a very important factor when addressing markets. The Federal Reserve deferred an increase in its headline interest rate during the September meeting to – at the very earliest – December. The decision calmed some investor concerns for Asian currencies. This is because US dollar financing in Asia has risen substantially in recent years, and to defend local currencies in the face of a stronger dollar would involve using up valuable foreign currency reserves.
In the meeting to discuss the decision, Fed Chair Janet Yellen stated that “heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets”. Yellen did continue to state that the importance of this emerging market vulnerability should not be overplayed in terms of its ramifications for US monetary policy. However, one of the key reasons quoted for delaying a rate rise was weaker US exports, and China is the US’ second largest trade partner, nestled between Canada and Mexico.
Uncertainty is set to remain a big part of the investment landscape for the near term, whether attributed to a Fed rate hike – which the central bank still expects to happen in 2015 – or additional concerns surrounding global economic growth. The importance attributed to currency ‘wars’ however, could be exaggerated. In our view, investors need to remain mindful of currency moves, and emerging market currencies are expected to remain weak and volatile. No matter what China’s motives are in weakening its currency, it is the US that retains the upper hand in economic strength.