When an important variable is un-hinged, uncertainty goes up, at least for a while. This is the first reaction to the change in FX policy just announced by China, regardless of the more fundamental implications once the change is understood and days of market reaction show the new dynamics. Key here is whether this is the beginning of a steady sequence of 2% depreciation days.

Circumstances make it difficult to interpret whether the motivation is poor growth, or to accelerate reform to comply with the IMF, or to preserve reserves. They all point in the same direction and help China defend the decision.

Despite the fact that it is too early to say whether this apparently important change will produce a meaningful FX depreciation in the short-term, we can make a few observations:

·      China was just informed by the IMF that its currency would not become a reserve currency this year because it is not transparent enough, not market driven. Well, this looks like the appropriate response in order to make it for this year’s cut. Whether it is enough will depend on how the spot FX is determined in the next weeks and months.

·      This is clearly a change towards adding FX policy to the macro toolkit. Until now China was active on fiscal and monetary policy, making FX policy a source of stability. Now the FX can move, which adds a new very significant moving part to the global macro picture.

·      Chinese deceleration is a common global macro fear. We have written many times about convergence, the fact that it is natural to expect Chinese growth to gradually converge to 4-5%. The obvious question is how soon. This move can be interpreted as confirmation the economy is decelerating and that traditional fiscal and monetary policy tools have become less effective. It confirms global macro fears of lower growth. Currency moves do not produce global growth, though they help reduce imbalances. However, currency depreciation reduces local consumption and increases the relevance of exports, which is the opposite of what the government had said they are after.

·      In a world of secular dollar strength, the Chinese currency was not depreciating with the rest. This decision aligns China with the rest of the world in that respect (if a more meaningful depreciation materializes).

·      Capital outflows from China is yet another justification. Around 10% of reserves have been used to fund those at the fixed exchange rate in recent months. An equilibrium exchange rate reflecting capital outflows and weaker exports could be a weaker currency, which adds uncertainty to the global macro picture. A more flexible Chinese FX market has serious implications for Chinese portfolios, pushing them to diversify internationally.

·      Thus, the simplistic big picture implications are negative for commodity prices and the countries producing them, negative for Asian countries now bound to fall into a currency war with China, as well as other countries competing with China in the global production chain. The global consumer benefits, as it has been doing so for the last 2 decades of access to cheaper Chinese products. Thus, containment on global inflation. The latter should make the Fed hiking path an even milder one, maybe closer to what the market expects as opposed to the Fed forecast.

·      Unless the Chinese currency depreciates quickly in a non-trivial way, this should not have an effect on the Fed’s likely first hike in September.

This is a fundamentally important step for China on the road to further liberalization (if it materializes that markets will have a role in setting the fixing each day), which is positive in the medium-term. An important price in the global economy seems bound to be market driven, which is positive for an efficient global resource allocation. However, in the short term it is bound to produce uncertainty, especially if the depreciation is allowed to go its course. Forwards point to a 5-10% move over 12 months, which is not a crisis move by any means. But for CNY it is a move the global economy has not seen in recent years in such a short period of time. The pace of these moves tends to be more important than the magnitude. Thus, the key here is whether this was a one-time move today, with only gradual and infrequent further depreciation, or if this is a fundamental change to a freer market producing a steady sequence of 2% moves that quickly accumulate. If the history of Chinese reform is of any use, the process will be managed and be gradual in a way to minimize uncertainty.

If the process were managed, the short-term effects would be gradual and less violent. However, if the depreciation of CNY through time accumulates to a decent move (around 10% or more), the fundamental implications are the same.

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