China Devalues - More Consequences

The government's reasons for launching the reform will decide the yuan's exchange rate in the future. If it's economic, then depreciation will continue because the dollar is expected to become stronger. If it's political, depreciation will not last.

- Xu Gao, chief economist of Everbright Securities

A lot hangs on that observation: a modest devaluation and/or sustained depreciation could help China’s economy a lot. A chaotic devaluation triggering capital flight and undermining the stability of the deposit base would be disastrous.

Whilst markets fret about the potential negative consequences of China’s devaluation, it is easy to forget that it does at least go some way towards correcting a major  policy mistake - the unwillingness to ease monetary policy in the latter part of 2014 to offset the tightening impact of keeping the Rmb effectively tied to the soaring dollar. July’s stockmarket collapse pointed very strongly to the need for a more dramatic about-turn in monetary policy than had previously been tolerated, and August’s devaluation, if nothing else, achieves that.

What is more, by releasing the de facto dollar peg, China in theory gains the freedom finally to operate a monetary policy which serves the cyclical needs of the domestic economy. And although China’s has a more positive inflationary dynamic than consensus is prepared to admit, there is no doubt that more accommodative monetary conditions stand the best chance of improving the purely cyclical economic dynamics.

So far this year, PBOC edged only half-heartedly towards loosening policy, which began to bear similarly modest fruit in May, June and July’s monetary data. In particular, July’s ‘surprisingly good’ money and credit data  - M2 up 13.3% yoy, new bank lending of Rmb 1.48tr - need substantial qualification The attempt to prop up the stockmarket inflated both bank lending and M2 growth whilst simultaneously diverting credit away from the ‘real economy’. (See this for explanation).  And the tepid loosening seen in May, June and July gets a substantial boost by from August’s devaluation.

Historically, where changes in China’s monetary conditions have led, domestic demand and industrial momentum have usually followed soon. Whilst July’s industrial momentum was weak to an extent which offset June’s relative strength, and July’s domestic demand data was just plain weak, in both cases,  the 6m momentum trendlines, although in negative territory, are inflecting up. It is a fair bet that this modest upward inflection will be maintained into August and probably beyond.

And in addition, prior to the devaluation we were already looking at a modestly rising CPI (and thus falling real interest rates).  Unless accompanied by destabilizing capital flight, the devaluation raises the likely inflation outlook, rather than depressing it into a possibly deflationary scenario.  (Nb, this is not the view of consensus, which is looking for inflation of 1.5% in 3Q, 1.8% in 4Q and a fairly steady 2% in 2016. Thus the 1.6% yoy rise in July’s CPI was not expected.

Even before the impact of Rmb devaluation is taken into account, those CPI forecasts look too low to me: I’d be looking at 1.8%-1.9% in 3Q15, 2.3%-2.6% in 4Q15, rising to 2.9%-3.4% in 1Q16 and 3%-3.7% in 2Q16.

But the improvement in China's monetary conditions will also have an impact on global monetary conditions. Indeed, it will accelerate an upward inflection point which had already arrived in June.

My monetary conditions indicator track what I believe to be the four key things one needs to know about an economy’s money: how much of it there is;  what happening to its domestic price;  what’s happening to its international prices; and what’s happening to its time-value. For my global monetary conditions indicator, I weight for the US, Eurozone, China and Japan according to 5yr dollar GDPs average.  The key thing to know is that conditions have been tightening since 2Q14, reaching their nadir in 2Q15, since when they have been in tentative recovery.  That recovery gathered pace in June and July, and China’s Rmb depreciation will almost certainly accelerate that recovery significantly in August.  More, during the early part of this year, monetary conditions were deteriorating in the US, China and even Japan, and easing only in the Eurozone.  By August, my estimate is that they will be improving in China, in the US and in Japan, whilst deteriorating slightly in the Eurozone.  Overall, however, the upward inflection point has already arrived.