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China devalues currency, moves to market-based pricing

In its effort to shore up its slowing economy and take steps to facilitate the inclusion of the yuan in the IMF’s basket of reserve currencies (Special Drawing Rights or SDRs), China has effectively devalued its currency twice in two day.

On Tuesday, China surprised the markets by announcing a 2% devaluation of the yuan. Then on Wednesday, the People's Bank of China (PBOC) set the yuan's midpoint rate lower than Tuesday's closing market rate, resulting in an almost 4% devaluation of the yuan in two days against the U.S. dollar. The yuan is fixed against the U.S. dollar.

A lower yuan will make exports to China from the rest of the world more expensive and conversely, Chinese exports to the rest of the world cheaper.

Incidentally, since the unpegging of the yuan in late 2010, the currency has gradually appreciated against the US dollar. It has continued on its stable path even as other major currencies declined on the back of stimulatory central bank policy.

In our opinion, the PBOC has devalued the yuan for three main reasons.

Foremost among them is that the domestic economy has been slowing as the government focuses on rebalancing towards more domestic consumption. The PBOC has responded to the slowdown by cutting both interest rates and the reserve requirement ratio. We believe this easing policy is inconsistent with a continued appreciation of the currency, and certainly inconsistent with the tightening bias of the US Federal Reserve, which has been the primary driver of USD strength

Secondly, since the yuan has been fixed against the strongest global currency, the USD, prior to the pricing regime change, the yuan had essentially appreciated by approximately 20% against other major currencies, namely the Euro and the Yen. In addition, the yuan had also appreciated 20+% against the basket of emerging market currencies comprising the JP Morgan Emerging Markets Currencies Index since June 2014. This has been a source of concern for the PBOC because of the adverse impact on export competitiveness against all countries, except the US.

Thirdly, the pricing regime change is seen as a necessary precursor for inclusion of the yuan in the IMF’s currency or basket of reserve currencies, which is currently composed of the US dollar, the Euro, the pound sterling and the Japanese yen. The IMF reviews this basket every 5 years and on August 4, commented that the Chinese yuan “is the only currency not currently in the SDR basket that meets the export criterion. Therefore, a key focus of the current review will be whether the yuan also meets the freely usable criterion in order to be included in the SDR basket.”

We believe this comment was a catalyst for the timing of the change in the yuan pricing regime. As another important sidenote, in May 2015, after a decade-long gradual revaluation of the yuan, the IMF declared that the yuan was no longer undervalued. This declaration was an important precursor for considering the inclusion of the yuan in the SDR basket.

Looking ahead, we were expecting the revaluation of the yuan downward to reflect both the domestic easing bias and the significant devaluation we have seen with most developed and emerging currencies, with the notable exception of the USD. This transition to a market-based pricing regime for the currency is very positive in the longer term, and might be one of the final steps needed for the inclusion of the yuan in the IMF SDR.

Following the devaluation, it is expected that the Chinese economy will continue to moderate after more than a decade of double digit growth. In spite of its slower growth, China’s GDP growth will continue to be stronger than that of developed economies. From a bottom up stock pickers’ perspective, there continue to be very attractive investment opportunities in secular growth sectors like consumption, education and technology in China.

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