Chinese devaluations and the effect on U.S.

Do these guys know what they’re doing? During China’s long march to its status as the world’s second-largest economy, the country’s leaders earned the grudging respect of investors for their competence, if not for their humanity. The Chinese government seemed aware of the risks posed by debt-driven over-investment and steadfastly sought to wean its economy from dependence on exports.

In recent years, however, a stubborn economic slowdown has complicated those plans, and there are hints of desperation.

After a government-encouraged bubble in equities burst earlier this year, authorities stepped in to prop up prices. Then came last week’s abrupt devaluation of the renminbi, a move that took investors by surprise and triggered a burst of panicked selling virtually everywhere.

For years, the Chinese government has been under pressure to allow its currency (also known as the yuan) to appreciate. Though economists disagreed as to whether China was a currency manipulator, the country’s massive trade surplus was evidence that argued strongly for a guilty verdict. Beginning in 2005, however, China allowed the renminbi to inch higher while still keeping it contained within a tight trading band. Over the last decade, the renminbi has appreciated about 20% against the dollar.

But with China’s economic foundation looking increasingly shaky, the government changed course, albeit under the guise of allowing market forces to determine the renminbi’s value. At one point, the renminbi had dropped by about 3%.

Boring but important

Devaluations are no trifling matter. Currencies are the tectonic plates of the global financial system, moving slowly and out-ofsight, grinding against one another until accumulated pressures shake asset prices worldwide.

Since the Bretton Woods agreement in 1944, there have been numerous financial quakes. In 1971, President Richard Nixon discontinued the dollar’s convertibility into gold at $35 an ounce, a move that allowed market forces to fully determine the greenback’s value. By the late 1970s, the dollar had fallen by 20%, contributing to rising inflation and a lost decade for stocks and bonds.

The ensuing “Super Dollar” period that began when Federal Reserve Chairman Paul Volcker raised benchmark interest rates to fight inflation also contributed to sharp moves in U.S. financial markets. Stock and bond prices eventually soared as inflation moderated and Volcker took his foot off the monetary brake, but a worrisome trade deficit (most notably with Japan) led to the so-called Plaza Accord, in which major trading partners agreed to engineer a lower dollar.

By 1987, the buck had dropped by nearly 30%, pushing up U.S. inflation and interest rates. That spring, a rout in the bond market foreshadowed the October stock market crash.

In the 1990s, currency crises were confined to emerging markets, most notably in the round of currency devaluation across Asia in 1997. That crisis caused the Fed to keep interest rates lower for longer and may have set in motion the chain of events that led to the formation of the two destructive asset bubbles in the United States.

Fallout

The Chinese devaluation handed U.S. investors an excuse to do what some had been itching to do anyway — sell. In recent months, there’s been a subterranean correction developing, with numerous technical indicators turning neutral if not outright bearish.

Market breadth, or the ratio of advancing to declining stocks, has been falling since late spring, as has the number of stocks making new lows compared to those making new highs. Also, well under half of S&P 500 companies are trading below their 200-day moving average, a sign that an intermediateterm downtrend is underway.

More fundamentally, a lower renminbi could cause a wave of competitive devaluations in developing economies, thus reinforcing deflationary pressures in the United States and Europe. If so, the Federal Reserve might delay the “lift off” date of its monetary tightening cycle, which would be bullish for bonds and for companies with minimal exposure to China.

From China’s perspective, allowing market forces to take the renminbi lower will bolster its case for inclusion as a reserve currency while backstopping the dangerous slide in its economy.

Those potential outcomes suggest that Chinese leaders know exactly what they’re doing, even if the list of workable solutions is growing distressingly short.