Yuan devaluation implications explained

We spoke yesterday of the results of China’s sharemarket collapse but what about the cause?  The core issue is they are devaluing their Yuan to try and spur on growth through a more export friendly currency.  The Daily Reckoning’s Greg Canavan explains the implications well as follows.  Its longish but worth the read to understand what is happening at the moment :

“China is losing control of its currency devaluation. In the process, it has unleashed a deflationary storm.

The People’s Bank of China (PBoC) lowered the reference rate for the yuan versus the US dollar to the lowest point since last August (a move of 0.5%). And after this the Chinese market tanked immediately at the open.

Within 29 minutes, stocks plunged 7% (again) and the market wide trading halt kicked in (again). The problem for China is that it has a lot of ‘hot’ money nervously pacing around its economy. And with each decline in the exchange rate, a chunk of this hot money can’t take the strain anymore, so it flees.

Think of it as one giant margin call against China. As China tries to devalue in an orderly fashion, speculators make it hard by rushing in to take advantage of the trade. This causes an orderly devaluation to become disorderly.

For years, ‘hot’, or speculative money flowed into China. It came via cheap US dollar loans (or using commodities as collateral) and amounted to leveraged bets on a slowly appreciating yuan versus the US dollar. No one knows how much hot money flowed in, but it represented a decent amount of China’s at one point US$4 trillion foreign exchange pile.

Now that pile is shrinking as the money escapes, and flows back to where it came from. This is an important point. Firstly, it represents a tightening of credit in China. That’s not good for an economy struggling for growth right now.

And when I say money ‘flows back to where it came from’, I mean flows back to the bank or institution that made the loan. When you repay a loan, the money effectively disappears.

In the same way that new loans create demand in an economy, the repayment of outstanding loans extinguishes demand. As far as I can work out, this is what’s causing big falls across stock and commodity markets.

That is, as leveraged bets on the yuan unwind (meaning debts are repaid) demand for ‘risk assets’ (stocks, commodities, high yield debt) falls, and so the price for these assets falls too.

As evidence of the hot money escaping China, yesterday the PBoC reported a larger than expected drop in foreign exchange reserves of US$108 billion during December. Keep in mind the carnage didn’t kick off until the New Year so you can bet that this outflow will pick up pace in January.

The question is how long will this go on for? Certainly, markets can’t sustain the pace of the past few days for much longer. Calm will be restored. But no one will be certain whether the selling is over for good.

More importantly, investors are quickly losing confidence that authorities have the situation under control. The post-2008 market recovery was in large part built on confidence in global policymakers. It was especially built on confidence in China’s policymakers. That is now waning.

This is partly the reason why you’re seeing gold come back into play as a safe haven currency.”

As the Aussie dollar drops on the back of this it is yet again worth reminding newcomers that a falling AUD sees your gold and silver price increase.  Don’t just watch the USD spot price on the news, it’s the combination of that and the AUD you need to watch.  We are seeing the double whammy of a rising USD spot price as investors seek a safe haven as markets rupture and a falling AUD turbo boosting it up (for Aussies) as the yuan is devalued.

China has only devalued the Yuan by relatively small amounts so far and you’ve seen the carnage.  The market is anxiously waiting to see if they up the ante and make a big cut.  If so, brace yourself….