For years I have compared China’s tight hold on its currency as akin to holding a wolf by the ears – you don’t like the situation you are in, but you don’t want to let it go either.  This week we got a taste of what it is like to have the wolf running free.

The People’s Bank of China (PBoC) announced a 1.9% devaluation overnight Tuesday and, more importantly, announced a new process for how the currency will trade going forward.  The ripple effects were wide and significant, although intertwined with a lot of other market drivers these days.  But from a high level, the most significant repercussions are that:

  • Equities and bond yields worldwide suffered, as the move introduced both volatility and was seen as a response to their slowing economy.  Companies with exposure to China had a particularly hard week.  Apple is a good example, as their iPhones just got more expensive in China.
  • Emerging market currencies and commodities also tanked for the same economic reasons.  The currencies of Malaysia and Indonesia hit lows not seen since the 1998 Asian currency crisis

The crucial question that we and many in the market have is the second part of the action overnight after the one-time devaluation.  The People’s Bank of China (PBOC) says the previous day’s close will serve as the basis for the next day’s trading.  Whether or not they let that happen is critical.

Previously the PBOC took a rate from the previous day somewhere in the range, but importantly, they had essentially full control of the previous day’s setting.  The new verbiage indicates that they are ready to let the market push trading one way or the other and indicate where the starting point is for the next day’s trading.  If they actually do that, then we have a real moving currency on our hands, albeit one that moves slowly. 

My view: If we do see what seems to be a sea change in their control of the currency, then this will be one of the best developments for China and the global economy this year. China had to move to a market-based system, and if they follow this through, will see much more solid economic growth in years to come.

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