China’s devaluation in context

China is at the center of the recent financial market volatility, which has caused the VIX index to double over the past week. The turmoil reflects a complicated mix of concerns over macro and market fundamentals, exacerbated by the recent exchange rate adjustment.

Even though the Chinese devaluation last week was very small in absolute (approximately 3%) as well as in relative (compared to other EMs or even DM currencies like the EUR) terms, it has caused a lot of speculation. We remain convinced that the main reason for the devaluation is a first step in a very long process towards a free floating currency. This is a positive development, welcomed by the IMF, even though it causes volatility in the short term. We do not think that export competitiveness was an important factor behind the decision, even though the timing of the decision and recent economic data have led some analysts to believe that could be the main reason. And at least some of the current sell-off in financial assets around the world is related to concerns about the health of the Chinese economy.

Most equity markets sold off sharply on Monday but emerging market assets, especially those related to commodities, have been among the hardest hit and several countries have devalued their currencies over the past week. We believe assets may correct even more as there are few obvious positive triggers in the short term and markets tend to overshoot. A number of commodity dependent currencies with fixed pegs look particularly vulnerable. We do not, however, think the RMB will move much more in the short term. The band is likely to widen gradually over time but the next step may take time given the volatility caused by these first moves.

In the meantime, the focus will return to the anticipated FED hike. The recent volatility has reduced the expectations of a September lift-off. A delay of the hike would support sentiment and EM assets in the very short term, but we think that US interest rates will stay exceptionally low in any case and therefore believe that it is better to get the first hike out of the way. EM assets have already corrected massively and the lift-off could, somewhat counter-intuitively, mark the beginning of the end for the negative EM sentiment.


Marcus Svedberg is chief economist at East Capital

Close Window
View the Magazine

You need to fill all required fields!