China Devalues Again, Markets in a Tizzy

Another day, another China-centric market sell-off, with the US indexes deeply in the red following losses all over the world. To say that markets have been volatile in the New Year would be an understatement.

One recurring theme of market activity in the New Year has been the renewal of China fears, which in some cases are even more pronounced than was the case last Summer. Growth concerns about China are nothing new—they have been with us for almost three years now. What is new is the market’s fixation about developments in the Chinese stock market. We saw this for the first time in a notable way last Summer and we are seeing that all over again this week.

Given the predominantly domestic investor base of the Chinese stock market, the reaction of global stock markets appears overdone. But while part of the reaction could very well be of a knee-jerk nature, there is a logical and rational explanation for investors’ fears.

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Please keep in mind that the trigger point for last year’s sell-off in Chinese stocks was the government’s devaluation of the currency. Driving the fear then was the narrative that China’s economic ground reality must be even weaker than officially acknowledged if authorities had to resort to the beggar-thy-neighbor policy tool after trying fiscal and monetary stimulus measures.

It was this loss of confidence in the official Chinese narrative—more than any perceived relationship between Chinese stock market and that country’s underlying economy—that gave us last Summer’s sell-off. This confidence was partly restored as a result of the subsequent stability in China’s currency and stock market. But all of that came back with a vengeance this year, with the trigger again being the currency devaluation.

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The Thursday devaluation by China’s central bank was so unnerving for local stock market investors that the Shanghai stock market’s circuit breakers got triggered immediately following the start of trading session, resulting in the shortest trading session in that market’s history. The sell-off in other Asian and European—and now American—markets, is effectively a reflection of the confidence issue in the official Chinese narrative. Global investors are effectively concluding that China’s official stimulus measures must not be working for the leadership to be resorting to currency devaluation to jump start exports and the factory sector.

This is a legitimate concern among global investors, but it may not fully explain the ground reality. The fact is that the Chinese yuan has been pegged to the dollar for a long time, as a result of which it got appreciated as the dollar strengthened over the past year, which has been weighing on the country’s export competitiveness. The currency is now effectively pegged to a basket of currencies and the central bank has been steadily trying to adjust the value of the currency in-line with that basket. But the market still perceives the authorities’ devaluation as reflective of the country’s weak economic outlook.

The bottom line is that there are legitimate reasons to be concerned about the China situation. But the ground reality isn’t as grim as would be warranted by recent market activity.

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