Markets are buzzing about the Chinese government’s surprise decision to devalue their currency, known as the yuan, leading to a 2 percent drop in the yuan’s value in Tuesday trading, the largest one-day decline ever.
The question is, what does it mean?
The markets—all of the markets—supplied some preliminary answers almost immediately.
1. It gives the Federal Reserve another reason to delay raising interest rates.
The yield on benchmark 10-year Treasuries fell more than 5 percent in U.S. trading today, moving down to 2.12 percent in early afternoon. So the most immediate practical impact of China’s move in the U.S. may be that mortgage rates stay lower for longer.
The idea is that the Federal Reserve may stand pat because weaker growth in one of the U.S. major trading partners might help convince the Fed that conditions are still soft enough to keep the Fed funds rate at the near-zero level it has occupied since 2008. Whether that’s enough to offset strengthening domestic labor markets, which are expected to prompt the Fed to raise rates in either September or December, remains to be seen.
2. It’s bad for commodities—and good for commodity buyers.
Immediately, the move means China will pay for oil, copper, coal and other commodities with cheaper yuan. It may also imply that authorities are worried about the Chinese economy weakening more than the already disclosed dip in gross domestic product growth to an annual 7 percent clip in the first half of the year, leading to lower demand for commodities.
The second part of that equation is one reason why oil dropped 4 percent on the news. Copper dropped 8 percent. That’s great if you’re filling your tank in the U.S.—or making pennies. (Chinese airline stocks got hit hard, as investors factored in the effect of paying more yuan for fuel but discounted the effect of cheaper crude). But less-valuable Chinese currency is not so good for exporters who want to sell manufactured goods that include copper, for example, or that are made in factories powered by Australian coal.
The impact on their costs will cut into any benefit they get from selling their goods more cheaply to dollar-using buyers.
3. The falling yuan may force other countries to devalue their currencies.
Currencies of Australia, Malaysia and South Korea fell in tandem after China’s move. But an analysis by Morgan Stanley in March predicted that a 15 percent drop in the yuan, much larger than today’s move, would cause a 5 percent to 7 percent drop in other Asian currencies.
4. China’s overall impact on U.S. growth will be small.
The move today isn’t big enough to offset the yuan’s appreciation over the last year, so it’s not likely that it will immediately affect China’s growth rate by itself, Goldman Sachs analyst MK Tang said in a note to clients. Because the People’s Bank of China’s policy shift changes the government’s formula for valuing the currency to give greater weight to market prices in a system that is a hybrid of state and market control, it’s too soon to tell whether the 2 percent drop will be all that’s in the pipeline, Tang explained. But even a 5 percent drop wouldn’t meaningfully affect China’s exports, Morgan Stanley’s Helen Qiao said in a March 6 report.
If China’s growth did slow more sharply, the impact on the U.S. would be minor. Goldman Sachs analyst David Kostin says a 1 percentage point drop in China’s annual economic growth would shave 0.06 percent off U.S. gross domestic product. That impact is already showing up in second-quarter reports by companies such as Caterpillar, 3M and United Technologies, suggesting it would be concentrated among industrial companies.
That suggests the 2 percent decline in U.S. stock market averages today is overdone.
5. China’s real goal may be prestige—and some longer-term stability.
China has been making an all-out push to make the yuan the fifth currency recognized by the International Monetary Fund as an international reserve currency, a designation that could be formalized as soon as next month.
To win so-called Special Drawing Rights status, China has to demonstrate that its currency is “freely usable,” a conclusion the IMF has refused to draw as recently as 2010. The push for special drawing rights is pressing China to reduce capital controls in general and may, in particular, be driving the move toward a more market-based way of valuing the yuan, according to a Bloomberg analysis in March.
The results could include convincing more central banks across the world to hold reserves in yuan, stabilizing its value, or to be able to buy commodities and other goods priced in yuan, according to several Asia-based experts cited in Bloomberg’s piece. Special drawing rights might also cut borrowing costs for Chinese exporters.
Looked at that way, China’s move may be trading some short-term pain for the promise of longer-term gain.
—By Tim Mullaney, special to CNBC.com