The last time China’s currency did this, markets crashed

China’s currency, the yuan, has seen its biggest drop since 2015. And with a slowing economy, it won't be raising interest rates. John Stepek explains how that will affect the global economy, the markets, and you.

The Chinese yuan has fallen by more than 3% over the past week.

Why should you care about what’s happening with exchange rates, let alone the price of a relatively minor currency (in global reserve terms) like the yuan (or renminbi)?

Well, because the last time this happened markets crashed. Forewarned is forearmed, and all that.

China’s currency just saw its biggest drop since 2015

Foreign exchange rates are good indicators of where capital is flowing to and where it’s flowing from. Ultimately, asset prices are driven by changes in capital flows. As for what drives capital flows – a good rule of thumb is that capital flows to where it is treated best. And right now, that’s not China.

The last time the yuan weakened like this was in August 2015 when China was in the midst of another economic slowdown. Now, you probably don’t remember the panic of 2015 because it didn’t really end up amounting to much and it’s been a hectic few years since then.

But it’s worth noting that China’s 2015 slowdown was one factor that prevented central banks in the developed world from raising interest rates.

So what’s going on?

Most obviously, there’s Covid. It’s easy to forget now, but around this time two years ago, when the UK was in the depths of lockdown, we were all looking to China to try to figure out what re-opening would look like, as lockdowns were just starting to end there. Now China appears to have gone back to square one with extremely severe lockdowns.

Secondly, this is happening at a time when China’s economy has been on shaky ground for quite a while. This is probably best exemplified by the slowdown in the property market which caused all the talk of “China’s Lehman moment” a few months ago.

Thirdly, as a result of all this, China is now on the wrong side of the central bank rate-raising cycle. China’s slowdown means it’s not going to raise interest rates – but the US is, and, all else being equal (it never is, but rates matter more than most things) higher rates will attract more money than lower rates.

Anyway, last time this happened markets got very wobbly, which is one reason why central banks decided against raising rates.

As you may well have noticed, markets are pretty wobbly right now as well. So a few questions arise from all this.

The Chinese slowdown complicates matters

This slowdown in China appears to be here to stay.

As Bill Bishop, who writes the China-focused Sinocism newsletter, notes: “it is hard to be positive about the economy or the markets in the face of increasing lockdowns of indeterminate length and intensity... even if policymakers were to announce bigger stimulus measures and rate cuts, how would the effects transmit through an economic system increasingly held hostage to the current anti-epidemic policies?”

This is a new situation for the world. Markets have been used to the idea that China cannot allow economic growth to slow, because that would mean social unrest and not hitting its GDP target, which would embarrass the Communist party.

This was true to an extent – China bailed the world out in 2008 and when the 2015 slowdown hit; it also eased monetary policy. The world is not used to a scenario in which China is not operating as the growth powerhouse of last resort.

However, China is throwing a fly in the ointment when it comes to the idea of developed-world central banks stepping back from tightening monetary policy.

The problem with zero-Covid measures in China is that they are going to mean that the mess made of global supply chains will continue. It’s quite possible that at some point down the line this might mean we see great piles of inventory dumped at exactly the wrong moment.

But, given how long it’s gone on for, I suspect this really just means more pressure for more permanent solutions and more of a drive towards “reshoring” – in all, a further move towards “just in case” rather than “just in time” (which implies companies carrying higher inventories as standard).

All of that adds to inflationary pressure, even as a struggling Chinese economy might take some pressure off commodity prices.

What does it all mean for you as an investor? I think you just have to understand that we’re going to be in for a more volatile period generally, and that you need to approach your portfolio with that in mind.

It’s a terrible cliche to say that markets hate uncertainty. But it is true to say that one thing we’ve been able to take for granted for a long time – that central banks would always open the floodgates at any sign of economic or market disruption – has now changed. That’s a pretty significant shift and one that will take some adapting to.

I’d stick with your bets on inflation; I’d hold some gold (it’s handy to have in a panic); and I’d make sure you allocate more to cash than usual simply to have it around in case you need it or want it to take advantage of any opportunities.

Oh and subscribe to MoneyWeek magazine. You get six issues free right now.

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