The China currency devaluation explained

Mid summer (yes it is, really) is always a good time to hit the markets and the Chinese have done just that.

The Renminbi or Yuan is not a free floating currency. The Chinese have pegged it to the US dollar to provide stability. A free floating currency , particularly in an economy with ups, downs, and a certain lack of transparency, would fluctuate wildly. A pegged currency needs deep pockets and the Chinese have massive reserves – unlike the Swiss.

Whilst the Chinese economy was going well, the Yuan would have been very strong – creating a drag on exports but also bringing financial discipline of having to become more efficient. We’ve seen the opposite. When the Yuan should have been soaring, it was artificially held by the peg. Exports boomed and financial largess resulted in a semi pointless construction boom creating empty cities. Newly minted billionaires imported more Rolls Royce than any other country and the smarter ones moved their cash abroad as they had little trust in the home currency.

Nothing like a bursting bubble to create a response.

Money flowed from state sanctioned loans into construction and real estate. Boom times came and Condo flipping became a dinner party conversation piece. And then stock flipping became the next game – no one wanted to be left out.

As night follows day, so do bubbles pop. We’ve seen the news reports, every man, woman and even a dog with a brokerage account chased the market up, on borrowed margin. Then the stories changed to heart rending bankruptcy and worse as loans with no collateral were called in.

Hit the devaluation button

One thing leads to another. The stock market bubbles, bursts and panic starts. Politicians outlaw shorting stocks, margin loans and so on. Meanwhile the real economy is struggling and so the export machine must be brought back to health. Move the Yuan peg and, at a stroke, Chinese exports become cheaper for the rest of the world.

What happens next?

Retaliation! South Korea, Japan and every other exporting nation will have the D word top of their agenda. And stock markets? The DAX has lost almost 600 points in three days. What may well be good for China is of no help to exporters in Europe.

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