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  1. Home
  2. / Investing
  3. / Financial Services

China Propping Up the Yuan Could Hurt Investors in 3 Big Ways

China's attempts to strengthen its currency could hurt the world economy.
By ANTONIA OPRITA Jan 05, 2017 | 10:00 AM EST
Stocks quotes in this article: F, BA, LMT, GM

It must be great to be Donald Trump these days. He only needs to send out a tweet and the world does as he says.

Most recently, Ford (F) magically announced it scrapped plans to open a new factory in Mexico after a tweet from Trump threatened rival automaker General Motors (GM) with import tariffs for cars made in that country. Last month, the president-elect sparked a price war on military jets between Boeing (BA) and Lockheed Martin (LMT) by tweeting that Lockheed's jets were too expensive and that he had asked Boeing to come up with an alternative offer. (Ford and Lockheed Martin are part of the Dividend Stock Advisor portfolio.)

And now it looks like China itself, no doubt tired of Trump's constant accusations that it is manipulating its currency, is taking measures to deal with the exchange rate. The Chinese authorities are intensifying their attempts to stop the depreciation of the yuan, which has fallen by 14.5% against the dollar over the past three years, according to FactSet data.

The weakness of the renminbi, which has hit its lowest value since 2008 versus the U.S. dollar, has started to eat into the country's massive foreign exchange reserves and it is making Communist Party officials really nervous.

The talk in the markets is that investors are watching to see whether the government will defend the level of 7.0 yuan to a dollar -- the exchange rate was 6.9485 in early morning trading on Thursday -- or the $3 trillion threshold for its foreign exchange reserves.

For that, it will need to take drastic measures, which will have effects beyond China's borders. Three possibly negative consequences will be particularly important for investors from developed countries.

My colleague Alex Frew McMillan wrote a couple of days ago about fresh measures to control attempts by individual Chinese to take out money from the country. Those measures were introduced in order to stem the outflows that the depreciation has sparked.

If these measures succeed -- and I agree that's a big "if," as capital controls are usually porous unless China reverts to only allowing strictly commercial flows -- then foreign assets, in particular real estate, could suffer pretty badly. A lot of Chinese money went into property in hot spots such as Manhattan, London, Vancouver and Sydney.

This first consequence could become apparent quite quickly if the Chinese authorities' measures force investors to liquidate assets abroad. A chain of events that could lead to such liquidations already has been put into motion; the question is how far it will go.

On Thursday, the offshore yuan -- the Chinese currency traded in Hong Kong -- jumped by 1% after rallying by 1.4% against the dollar on Wednesday, its biggest daily rise in a year. According to Bloomberg, financial regulators have "encouraged" some state-owned companies to sell some of their foreign currency holdings.

It looks like the companies sold so enthusiastically that liquidity has thinned, sending the main offshore yuan overnight interest rate, the HIBOR, to a one-year high of 38.34% -- more than double the previous day's 16.95% level.

This kind of volatility is a second potentially negative consequence that investors might need to get used to should China proceed with measures to stem the currency's depreciation. The People's Bank of China (PBoC) might need to sell more of its foreign assets, such as U.S. Treasuries, to be able to buy yuan instead.

Such a step would weaken bond prices, which move inversely to yields, and would push up bond yields at a time when the Fed itself is thinking of raising interest rates. The Fed cannot judge how much the Chinese selling would influence interest rates because it has no way of knowing how much the PBoC will end up selling -- not even the Chinese central bank knows that. So it risks tightening way too much or way too little, and the market could swing wildly trying to price in the uncertainty.

The third major consequence of the Chinese efforts to keep the renminbi under control would be inflation, at a time when energy and commodity prices seem to have bottomed.

A stronger yuan will mean more expensive imports from China, and while it is true that multinationals could opt to move factories to cheaper shores, they won't be able to do it fast enough to escape price rises. Higher consumer price inflation would hurt spending power, thus slowing consumption, but it also would force central banks to tighten monetary policy at the top of the business cycle.

China's attempts to avoid being called a currency manipulator by Donald Trump risk destabilizing the global economy, including the U.S. economy. The president-elect should be weighing his next tweet very carefully.

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TAGS: Currencies | Markets | Regulation | Rates and Bonds | Treasury Bonds | Financial Services | Investing | China | Economy | Politics | FOREX | How-to | Risk Management

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