Warning: China Yuan Devaluation Could Spark the Next Stock Market Crash

Yuan DevaluationYuan Devaluation Sparks Stock Market Crash

The Chinese authorities have cut the value of the offshore yuan to its lowest level since 2011. The gap in the U.S. dollar yuan exchange rate is likely to extend much further. Their efforts have sparked a stock market crash in equities around the world.

But China’s devaluation of the yuan, affecting the U.S. dollar yuan exchange rate, and the decline in oil prices, even in the face of a potentially widening Middle East conflict, have generated the most bearish sentiment of all. It’s true that the Shanghai market has rebounded, but its two-percent gain will be under pressure again as European stock markets were all under pressure, Milan (-1.47%) being the worst behind Paris (-1.11%), while London lost 1.13% and Frankfurt lost 1.15%.

The yuan devaluation is just one more sign that the Chinese economy is suffering. In particular, the People’s Bank of China (PBOC) set the exchange rate with the dollar at 6.6915 (yuan per dollar), which, aside from historical references, is 2.1% lower than the level of 6.5506 per dollar set for the yuan onshore. The offshore yuan is accessible to anyone, while onshore is strictly under the supervision of the Chinese central bank.

Beijing’s attempt to block another financial market knockout blow, as happened last summer, appears to have calmed the “panic selling” effect in Shanghai for now. The PBOC is rumored to be preparing to add some 130 billion yuan (US$20.0 billion) of liquidity into the financial system through short-term loans to prevent the vulnerable yuan from suffering further. (Source: “PBOC Injects Most Cash Since September in Open-Market Operations,” Bloomberg, January 4, 2016.)

The commission that regulates China’s financial market regulators has also hinted that it would extend the limits introduced in July to avoid shareholders from engaging in a massive securities sell-off. The ban was introduced in July when the first, premonitory, stock market crash occurred to prevent investors who own more than five percent in a single stock from selling. The measure, which also applies to company managers, was to expire on January 8.

China Is Scaring the Global Economy

In fact, the limits may not work. They will not prevent a Chinese market crash or protect international markets from the negative sentiment. On January 4, another Black Monday, investors burned 264 billion euros in Europe and Wall Street suffered its worst opening since 1932. The five-year-low yuan against the dollar and the fifth consecutive decline in China’s manufacturing output have justified investors’ fears of an even more intense slowdown than expected for the Dragon and the global economy. Tensions in the Middle East between Saudi Arabia and Iran are merely adding to the bearish sentiment.

Indeed, the U.S.-based Blackstone fund, one of the biggest players in the financial markets, looking for “black swans,” that is assumptions over the likelihood of catastrophic and unlikely events that could destabilize global markets, predicts that China’s economy will grow at less than five percent in 2016! That is a rather creepy prediction, which could plunge markets if taken seriously. (Source: “Byron Wien Announces Predictions for Ten Surprises for 2016,” Blackstone Fund, January 4, 2016.)

Perhaps the PBOC’s intervention in support of the yuan against the dollar with its injection of 130 billion yuan (US$20.0 billion) served as a message to investors that it would keep an accommodative stance. Nevertheless, state support for the yuan has lost much ground against the dollar. The PBOC has used some of the major state-owned banks to sell yuan and buy dollars.

Yuan Devaluation More Harm Than Good

The weak yuan to dollar exchange rate could accelerate capital flight, with negative consequences for financial markets and the real economy.

Chinese stock exchanges, meanwhile, continue to suffer. Despite the PBOC’s intervention and the yuan devaluation, the latest Black Monday has put the fear of a Black Week in the markets in 2016. The news has spread like a contagion through global financial markets, sparking a global stock market crash on Wednesday.

The lower yuan, intended to stimulate exports against the likelihood of an even stronger U.S. dollar, will persuade investors to liquidate investments in China and Japan to avoid being hit by declines. (Source: “Chinese devaluation is a bigger danger than Fed rate rises,” The Telegraph, December 9, 2015.)

And then there is the often overlooked issue of China’s monster debt. Chinese companies have debts that amount to some $529 billion and most of it is not insured against fluctuations in exchange rates. The recent devaluation—and the possibility of additional ones—will add to the burden by several billion.

The real estate sector, in particular, has become even more exposed to foreign debt. Setbacks in this area would have serious repercussions on the entire Chinese economy, since the real estate bubble has served as one of the main drivers of internal growth.

But the PBOC has few tools left to manage volatility; regulations can only go so far, but it could try to cut the yuan rate again and lower the reserve requirement ratio for banks.