If feels as though all eyes have been on the Chinese economy this year, and rightly so. More recently, discussion has been around the possibility of a devaluation of the renminbi. Will it happen, and if it does, what outcomes might we expect?
Fidelity’s Portfolio Manager Casey McLean, unpacks this and more.
Implications of a one-off devaluation in the RMB
I think there is a possibility that a one-off devaluation in the renminbi (RMB) could happen for a few reasons.
Firstly, consumption in China has been weak due to households saving rather than spending. This is typical in a deflationary environment like China faces now. In fact, it's the worst deflationary environment we've had since 2008. Normally, in this type of environment, you would see lower interest rates, resulting in the currency coming under pressure, but China's kept interest rates relatively high which is now having an impact on growth. Additionally, the currency is not under pressure, especially when you compare it to Japanese yen, which is one of China’s key trading competitors who's being helped by their own loose monetary policy.
Secondly, China has been actively buying up US dollar assets. For example, gold reserves are up by about 30% in the last year, as well as an increase in assets like copper. This could be a signal that they are preparing for weakness in the RMB.
Thirdly, if we look back to 2015, we were in a very similar circumstance: the deflationary environment led to the People’s Bank of China (PBoC) undertaking a devaluation in August 2015. What resulted was the Purchase Price Index (PPI) bottoming a few months later and then turning positive. This transition back into an inflationary environment helped spur consumption but also helped spur exports and drive overall corporate profits in China.
Devaluation or depreciation?
At the end of the day, devaluation or depreciation has the same outcome; it lowers the value of the currency relative to its trading partners. In turn, exports become more competitive with the lower currency and therefore export earnings rise. This then translates into rising incomes for exporter workers, and eventually creates more optimism and buoyancy throughout the whole economy.
The key difference comes down to the signalling of those changes: one shows a deliberate direction that the central bank wants to go in (devaluation) and the other is the ebbs and flows of market forces (depreciation).
Devaluation is a determined action causing generally larger movement in the currency by the government, i.e., the PBoC, the central bank in this case. I think the risk of a devaluation, which is also an opportunity for investors, is there. It may be a lower probability risk, but we can see the possibility of it happening.
Winning sectors with a weakening RMB
I think the clear winners are going to be the exporters thanks to increased demand or potentially better profitability from their exports. This includes industries like auto, where China is now the largest exporter in the world, having surpassed Japan. Autos are facing tariffs in some markets, and devaluation may help offset some of those tariffs for e.g., Chinese EVs into Europe.
Lastly, industrial automation equipment may too benefit given their key competitors in these industries are Japanese exporters.
Losing sectors with a weakening RMB
I think the first and biggest impact may be those highly leveraged companies, with large foreign debt holdings. Fortunately, there's not that many in the listed market.
Other impacts will be on companies that are heavily reliant on USD denominated imports, i.e., commodities.
Finally, the tourism sector. There's likely to be a reallocation of tourism away from international into domestic. Like we saw during Covid, staycations were popular in China for the first time.
Implications for Chinese companies listed offshore
Issuance of convertible bonds is a new trend, notably in the Chinese internet sector. I think this trend is partly related to currency movements, but more so on the controls over currency flows out of China into offshore listings, primarily the US. There are soft limits, but no formal limits on how much these Chinese companies can send offshore.
So, convertible bonds can be issued overseas in US dollars at very low cost of capital and with large gap to the conversion price. Meaning it is a cheap source of capital with little dilution risk. These funds are being used to buy back shares in those offshore listings.
In addition, there is a long-term trend where Chinese companies are moving their primary listings back to Hong Kong or onshore. So, these convertible bond issuance achieves two purposes.
Lessons drawn from Japan
I think we're going to see some similar dynamics emerge in China as we’ve witnessed recently in Japan, and there are certainly lessons we can reflect on.
Japan has been in a depreciating environment for quite a while now likely due to its loose monetary policy, especially relative to many parts of the rest of the world who have been in interest rate hiking cycles.
If you look at the response by domestic investors during this period, they’ve focused on exporters, being that they're the net beneficiaries of a weaker currency. Given Japan does import a lot of their consumption goods, higher import prices have hurt domestic consumption.
Additionally, Japan is particularly fond of high yield investments which has also spurred investors to look offshore.
For international investor's, the Japanese market has done quite well in recent times, not just due to the currency, but also due to some corporate governance reforms. But when you translate this back into US dollars, the returns have been less stellar. One obvious way to mitigate that risk is to hedge the currency exposure.
Applying this to China, there is still a risk that a similar scenario could play out. But there are differences too.
In Hong Kong, the currency is pegged to the US dollar, so there is virtually no currency risk there, and other markets like Taiwan are not seeing the same pressure to depreciate their currency either.
