There has been a lot of news in the press in the last two days regarding the decision by the Chinese government to devalue their currency against the US dollar. As a result, we have gotten a number of incoming calls from clients regarding this news and what the relevance is to their portfolios.
Some of the concepts involved here are somewhat esoteric but we are going to try to make this as simple as possible.
Traditionally, currencies have traded on open markets and their relative value has been determined by market forces. What do we mean by this? Well, if the economy in the United States is particularly strong and, as a result, the Federal Reserve raises interest rates while at the same time the economy in Brazil is relatively weak and their central bank decides they need to lower rates, all else being equal the US Dollar will increase in value against the Brazilian Real. This is because capital is seeking a higher return and will go to where it receives a higher rate, in this example the United States. A lower Real does benefit the economy in Brazil because they can price things more cheaply in the US and still receive the same number of Reals. If the US Dollar was $1/$100 Reals and once the market re-prices it, after the rate changes, it now takes 200 Reals to buy $1 (weaker Real/stronger dollar) the Brazilian shoe company can now sell their shoes for $.50 in the USA vs. $1.00 before and still get that same 100 Reals in return. Now, that shoe company should be able to increase US sales as they are more price competitive. Over time, as the higher rates in the US slow the economy and the lower rates in Brazil accelerate theirs the currencies should gradually rebalance. Thus, weakening a currency is one tool of a central bank to attempt to stimulate its economy. Interestingly, one of the reasons the Greek situation is still taking so long to resolve is that by entering the Euro countries lost the ability to control their own currency and let the market balance their exchange rate. This has led to strong countries like Germany not wanting to devalue while a weak country like Greece needs to devalue. The inability of the Greeks to do this is part of the reason for the current difficulties.
Now, on to China. Considering that only about 30 years ago China was an agrarian communist state the evolution and growth they have seen in recent decades has been nothing short of phenomenal. However, given their communist history, many capitalist economic forces are still centrally controlled by the government. One of these forces is the value of their currency vs the US dollar. The Chinese government had set the exchange ratio of US$ to Yuan at a fixed rate. If the ratio got away from the fix the Chinese government would enter the market and sell Yuan and buy US$ or vice versa to maintain the ratio.
Why did they do this? A large part of Chinese economic growth was driven by the massive expansion of their manufacturing base driven by cheap labor. A large portion of this new production was shipped to USA and consumed by us. All of those good shipped to the US from China should have caused our US Dollars to be sent to those Chinese manufacturers and then exchanged for Yuan. This should have driven down the value of the US$ vs. the Yaun. However, the Chinese government wanted to make sure that their goods stayed competitive in the US market from a price perspective. If the US$ went down too much vs the Yuan the Chinese manufacturers would have to raise US$ prices to receive the same number of Yuan at home. The Chinese government worried that this may slow their economic growth and so they decided to peg the Yuan to the US$. Interestingly, until recently, most of the clamoring on this topic domestically was for the Yuan to increase in value vs. the US$ thus making US made products more attractive price wise to Chinese consumers.
However, with the recent slow-down in their domestic economy and weakness in their nascent equity markets the Chinese government decided to revalue their currency lower vs the US$. Just like the Brazilians in our original example they are trying to accelerate their growth by making their products cheaper in global markets. Also, they are likely trying to stoke inflation in their domestic Chinese markets. A weaker Yuan makes imported goods more expensive, as the importer needs more of them to get the same amount of their local currency back home. Inflation theoretically pulls forward demand as people go out and buy things now worried they may get more expensive later.
Generally, we have been raising cash in recent weeks and will likely be more cash heavy in the intermediate term.
Alec Bethurum Sr. Portfolio Manager