China has just announced that it will devalue the Yuan to the lowest it has been since 2011. In a complicated global economy, this move portends many possible threats to prosperity.
The Chinese economy is a major player across the planet, and as one of the biggest investment hubs of the last decade, a looming crash can carry a ripple effect that will be felt everywhere. Understanding what this means and its potential impact is important to making sound investment decisions this year.
What’s the Problem?
Over the last one to two years, global investment in China as reversed. What was once the go-to market for anyone looking for huge returns has now turned past stagnation and entered full-blown recession.
China had a long history of undervaluing the Yuan, which led investors to buy Chinese treasuries in spades. Furthermore, China tied the Yuan to the United States Dollar (USD) which has been steadily gaining value since 2011.
As the Yuan grew more expensive and Chinese markets became less enticing, they amassed a debt bubble. Now, preventing a complete economic crash forces the People’s Bank of China (PBOC) to make some difficult decisions.
What Are China’s Options?
The country needs to manage its debt. Current global markets value the Yuan at roughly 10 percent less than China does, making their foreign debts more expensive than the face value. While the economy was booming, China gathered huge reserves, mostly consisting of $4 trillion in U.S. treasuries. With this substantial reserve available, they have a few extra options. In general, they can make one of three choices:
- Defend the currency. This choice means that they will hold the value of the Yuan steady. International trades will have to be supplemented to make up the difference between China’s value and the global value.In order to do this, they will have to spend from their large reserves. Usually this is one of the primary reasons to build reserves in the first place, but experts wonder if even $4 trillion is enough to stave off the existing implosion.
- Do one big devaluation. The PBOC could choose to devalue the Yuan so much that it is underrated for global markets. This would force international trade to pull its value back up naturally.This would preserve the federal reserve and free the government to print more bills to settle the books, but it comes at a huge cost. The extreme and sudden inflation would devastate China’s vulnerable middle class, depreciate global currencies and probably force a global recession.
- Slow but maintain the natural recession. This option combines the other two, with small, incremented devaluations of the Yuan, increased bill printing and compensation from the federal reserve. So far, this appears to be the choice China has made.How Is China Implementing Their Choice?
Going the route of a more gradual recession, China’s first big move has been a modest devaluation of the Yuan. Ultimately, this frees about $100 billion in national credit that they can use to reset loans that are about to default.
This part of the move is only a band aid, as the renewed loans will ultimately default if trends don’t reverse. More directly, devaluing the Yuan can boost export and try to minimize GDP reductions.
Keep in mind that China is far more reliant on exports than most major economies. Despite these measures, the country still has to support the losses by using the reserve. In just a few months this year, they have already burned $700 billion.
What Does it Mean for the World?
Chinese sales of U.S. treasuries threaten to devalue the dollar, as the supply for USD investments could outpace the gradually increasing demand. So far the USD’s increasing value has outpaced that flooding market, but if things continue to get worse and China burns its holdings faster, the situation can reverse quickly.
Such an unexpected loss of value would be sure to slow investments across the globe and cause another worldwide recession. An opposite is also possible if the Yuan loses value too quickly.
Other currencies could be forced to devalue in response to the Yuan to maintain their export value. That can bring too much value to the USD and make existing debts more difficult to pay. This is why many American politicians and business owners are pushing China to keep the Yuan’s value as high as they can.
Regardless of China’s decisions, they cannot exit their recession easily or quickly. Investing in anything tied to Yuan is increasingly risky.
Regards,
Ethan Warrick
Editor
Wealth Authority
