Only a few days ago we were worrying about a weak pound. Now, though, markets are fretting about the weak Chinese yuan. You can be forgiven for being confused by this. If sterling’s weakness is a bad thing because it raises import prices and so cuts real incomes, surely yuan weakness is good for us, because it means cheaper imports from China and hence higher real incomes.
Only up to a point. There are two offsetting considerations which explain why stock markets have taken fright at the weak yuan.
One is that it threatens to ramp up the trade war. US Treasury Secretary Steven Mnuchin has called China a “currency manipulator” which is seeking to gain an “unfair competitive advantage in international trade.”
This is doubtful. Given the weakness of China’s economy relative to the US, some fall in the yuan wouldn’t be unusual. And only last month The International Monetary Fund (IMF) estimated that the yuan was, within a wide margin of error, “at the same level as warranted by fundamentals”.
The truth, however, has not always weighed as heavily with the Trump administration as some might like. Regardless of the facts, Mr Mnuchin has pledged to “eliminate” any advantage China will get from a weak yuan. That raises the spectre of higher tariffs.
This is bad for equities. It threatens to depress demand around the world, partly because tariffs are largely paid by American customers who thus suffer a loss of real income, and partly because weaker world trade hurts third parties: it is one reason for the recent drop in German industrial production.
Worse still, it creates even more uncertainty. And higher uncertainty has for years meant lower share prices – there is a strong correlation between policy uncertainty (as measured by Stanford University’s Nick Bloom and colleagues) and the dividend yield on the All-Share index.
The other danger is that a weaker yuan is a competitive threat to other countries – not to the US, whose exports tend to be much higher up the value chain, but to other poorer countries who compete more directly with China in low-wage export markets. There is therefore a danger of falls in other emerging market currencies as they try to compete with China. And this means a stronger dollar more generally.
Which is a problem. Not only do currency depreciations raise inflation, they also raise the cost of servicing dollar-denominated debts. At best, this worsens the cash flow of companies (many of which are now Chinese) who have borrowed in US dollars. And at worst, it means bankruptcies, defaults and losses for banks.
It is for these reasons that emerging market equities have tended to fall when the US dollar has been strong.
So yes, a weaker yuan is a problem. The hope for equities is that if trade tensions can de-escalate or the yuan recover, markets should rebound. But this is a hope, not a certainty.
