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What China's Currency War Means to You

Tuesday, August 11, 2015
Money and Markets
YOUR BEST SOURCE FOR THE UNBIASED MARKET COMMENTARY YOU WON’T GET FROM WALL STREET
You can also access this issue on our website.
China Goes to (Currency) War! What it Means to You ...
Market Roundup
Dow -212.33 to 17,402.84
S&P -20.11 to 2,084.87
NASDAQ -65.01 to 5,036.79
10-YR Yield -0.101 to 2.137%
Gold +$4.20 to $1,108.30
Oil -$1.51 to $43.45

By Mike Larson 

China is going to war! Not over islands in the South China Sea, but over the value of its money.

The People’s Bank of China launched an aggressive salvo overnight, devaluing the country’s yuan currency by 1.9%. That may not sound like much, but in the world of currencies, it’s huge. As a matter of fact, it’s the single-biggest devaluation since China adopted its current monetary system in 1994.

The devaluation comes as China’s economy and financial markets are increasingly on the rocks. Growth is slowing. Bad debts are rising. Exports just plunged by more than 8%, more than five times as much as economists expected. And the stock market has been tanking, suffering a series of huge swings the likes of which we haven’t seen in years.

Why is China taking this step? The PBOC claims it’s part of an effort to make the yuan’s pricing more market-based, and increase currency market flexibility. It said it would be a one-time move.

China is looking to give its exports a lift on international markets.

But that’s hogwash. The real reason it’s devaluing is the same reason several other combatants in the ongoing global currency war are doing it: To give their exporters a competitive advantage.

Think about it this way. Cutting the value of your currency is like running a sale on your goods. You’re telling the world: Buy from us … everything we sell is now 1.9% cheaper.

The problem, though, is that it also makes goods from all your competitors relatively more expensive. So all your Asian neighbors panic, and are forced to launch their own competitive devaluations to avoid suffering a competitive disadvantage. That’s why a basket of Asian currencies tanked the most since 2008 after China’s news hit.

At the same time, think about what signal you’re sending to global investors by devaluing. You’re basically telling them your economy stinks. Not only that, but you just made every bond, stock, or other asset those investors own that’s denominated in your currency worth 1.9% less.

So what are those investors going to do? They’re going to sell, that’s what. One estimate in this Bloomberg story is that every 1% decline in the yuan against the dollar alone leads to roughly $40 billion in outflows.

China has a huge pile of foreign exchange reserves – around $3.7 trillion. So it can withstand the pressure for a while. But those reserves have already dropped for four straight quarters, by about $300 billion in total. Worries over accelerating capital flight could reverberate through global capital markets.

“I can remember distinctly what happened the last time a major Asian currency crisis broke out in 1997-98.”

Moreover, I’ve been around the block for many, many years. I can remember distinctly what happened the last time a major Asian currency crisis broke out in 1997-98.

A wave of competitive devaluations swept through Thailand, Indonesia, Malaysia and South Korea. Then the crisis spread to Russia, and ultimately to U.S. stocks. The Dow Industrials plunged almost 2,000 points, or more than 20%, in just a few months in 1998 alone. And that was when the U.S. economy was in fundamentally much stronger shape than it is now.

Finally, this move is sure to worsen U.S.-China relations. U.S. manufacturers have already been suffering from a rising dollar, and politicians have lambasted China in the past for manipulating its currency to give its companies a relative advantage. This is going to increase those tensions significantly, and raise the possibility of retaliatory “trade war” type actions.

Bottom line: The capital markets were already getting more volatile and risky, as I’ve been warning for a few months. Now China is launching its most aggressive currency war in decades – threatening to add even more uncertainty and risk to the mix. So if you haven’t taken protective action, now may be a very good time to do so.

So what do you think about this move by China? Is the global currency war going to get worse now? What does it mean for the U.S. dollar, U.S. stocks, and your investments? And how about the politics of the move? Will U.S. officials (and presidential candidates) threaten retaliatory action in response? What will that mean for the markets?

Please do head over to the website and share your thoughts as this is a big market story – and I’m sure your fellow investors will appreciate hearing from you. I know I will.

Our Readers Speak

There was a lot of discussion over at the website already even before we got this China news, and I can only imagine it’ll heat up now.

Reader William S. said the Federal Reserve won’t be in a position to raise interest rates, even if it wants to. His take: “The Fed cannot raise interest rates because there is so much un-payable debt out there, any hike would cause an avalanche of defaults and bankruptcies. Even if some could handle a couple of 0.25% rises, they would bail at the second something happened, noting the pendulum swing.”

Reader Jim looked at the political implications of the latest climate change regulations, saying: “I’ll refrain from partisan comments on the proposed EPA rules and simply ask a question. Doesn’t it seem to you that we are getting an awful lot of far-reaching rules and regulations that profoundly affect our lives without ‘We the People’ having anything to say about it? No debate, no peoples’ representatives. Here it is, take it and like it. What happened to the legislative process?”

As for crude oil and the American export ban, Reader Robert C. said: “It’s about time these so-called geneses in Washington woke up. Exporting oil to Japan, who has no natural resources, will bring down supply and may cause WTI to rise.

“We should also bear in mind that Saudi Arabia will not cut production because they are out to put our frackers out of business. They feel betrayed due to our change in policy towards Iran.”

And Reader Mule was about as bearish as you could get on U.S. stocks, in light of the latest turmoil. The comments: “I’m the world’s second-worst gambler, but if I had to bet, I’d bet on a crash. This market is built on worthless paper and to worthless paper it shall return.”

Thanks for sharing everyone. It’s clear that topics such as interest rates, oil, and stocks are on the forefront of your minds. That’s why I urge you to stay tuned to Money and Markets for my latest updates in these volatile times. As I mentioned the other day, I’m more concerned about markets now than I’ve been in years – and that’s why safety and caution are watchwords to keep in mind.

Other Developments of the Day

BulletGoogle (GOOGL) is launching an ambitious corporate reorganization, one in which its core businesses will be reportedly separate from its more-ambitious, but costly non-core efforts.

Specifically, the company will form a new holding entity called “Alphabet.” It will own the existing businesses we think of as associated with Google, such as search, YouTube, maps, and so on. The company will also separate out its Google Ventures and incubator projects, as well as its smart home, high-speed Internet, and other businesses.

BulletChina may be going to pot, but Greece said it managed to reach a tentative bailout deal with its European creditors. The plan would give Greece up to 86 billion euros in aid, in exchange for the country adopting more comprehensive economic reforms. But it’s unclear if Germany will sign on, and whether Greece will get the first tranche of money soon enough to make a 3.2 billion euro payment to the European Central Bank on August 20.

BulletDeal mania is alive and well on Wall Street, according to tracking firm Dealogic. Global M&A could hit $4.6 trillion if the current pace of activity holds through year end. That would make 2015 even bigger than 2007, when $4.3 trillion worth of deals got inked. Then again, 2007 marked the peak of the great global credit bubble – so maybe this isn’t exactly good news. We’ll see.

What do you think about Google’s new version of corporate alphabet soup? Or the big wave of M&A? Any other stories catch your eye that I didn’t mention here? Then let me hear about them at the website.

Until next time,

Mike Larson

Mike Larson
Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for Bankrate.com. There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.
The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

For more information and archived issues, visit www.moneyandmarkets.com.

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