The Chinese currency devaluation: the view of a Little Englander – keep calm and carry on

This is not as dramatic and as myopically self interested as it looks. Nor is it beyond reason…

Yesterday’s allergic reaction to the devaluation of the Yuan is a reminder of how much investors have to keep in mind and how impossible it is to do that. We live in an ocean of connected facts and data and a sea of possibilities. Can an individual reasonably keep an eye on UK equities and at the same time follow the currency markets, weaving them into part of his or her investment strategy? The answer is ‘yes’ as a matter of logical principle but ‘no’ as a matter of practicality. I naturally keep an eye on Sterling, the US Dollar and the Euro but not the yen which is at the periphery of my attentive vision. Like many in the world of UK investment, I must be honest and confess I was taken by surprise at the devaluation of China’s currency. And so was most of the world by the look of the reaction to the event.

For ‘yours truly’, the big question about China, insofar as it relates to investing in UK equities, is can it maintain its rate of growth (whatever that may be) whilst trying to shift the economy from its hitherto overwhelming dependence on exporting and infrastructure spending, to one with a growing level of domestic demand? China has to do that because the previous economic model was unbalanced and unsustainable in the long run. The world needs a Chinese economy that begins to look more like mature western economies, with its own burgeoning domestic consumer demand. That is good for China because it brings diversification, stability and employment opportunities. It needs to have citizens who can buy Chinese manufactures alongside foreigners whilst, hopefully, also creating a growing demand for more of the goods and services made in the rest of the world. We eventually want it to import more than iron, copper, oil and luxury goods for its wealthy elite. It is that kind of economic development that is needed if China is to become the world’s largest economy. It needs to be a natural, fully complementary part of the commercial, global trading system. It is my working assumption that China will do that over time. Meanwhile, it needs to keep the show on the road.

It is too easy, whilst peering closely at the balance sheets and cash flow statement of UK companies to overlook the fact that Chinese exports have got very expensive in overseas markets. The Yuan has been pretty much pegged to the US Dollar and over the last year the Dollar has been strong. So it is a bit of a shaker to read that as a result of that, Chinese goods are some 14% dearer than they were a year ago; a bit of a problem for a country whose exports traditionally compete on price. That must obviously occupy the minds of market currency analysts and currency traders. Consequently, it seems that the Chinese authorities have allowed a managed downward float of the currency against the dollar, as it would no doubt do in a free market. In other words, in my estimation the Yuan is only doing what it would be doing in a fully free market system. The bad news would have been that the Chinese authorities had attempted to keep the currency pegged to the dollar at an economically (and politically) counter productive rate against Uncle Sam’s currently all conquering Dollar bill.

Obviously, there will be an adverse currency translation effect in the accounts of companies selling stuff in China. That obviously takes in the miners, oil companies, luxury goods companies and the suppliers of technology. These share prices have already been marked down in response. A weaker Yuan also encourages more domestic manufacturing in China for Chinese consumers, because overseas equivalent products will be a bit dearer. That is a good thing long term, because it nourishes local consumer industries a bit and prevents withering.

It is my big subjective “on the face of it” judgement that the Chinese government will be cautious and pragmatic in its economic policies, as it always tends to be. I do not see the men in Beijing starting an international currency war. I am happy to take them at their word on that. What they have done in recent days looks measured and reasonable, in allowing the markets a bit of room for changing the Dollar value of the Yuan. We don’t want them to follow in the footsteps of Nigel Lawson and Norman Lamont when they tried to keep Sterling pegged to the Deutsche Mark beyond the point of market realism. We also have the gloomy example of the bastard Euro to remind us of what damage too much inflexibility brings. I do not know how other currencies affected by this will react. Just leave it to the currency markets is my view and expectation. The dollar markets remain strong for the time being. In short, I do no think that this is game-breakingly bearish in its implications.