The yuan devaluation may entail significant consequences and accelerate the unwinding of the China carry trade. What does it mean for the global economy and the gold market?
The “one-off” devaluation was stretched a little today, as the People’s Bank of China set the yuan’s official exchange rate to the dollar 1.1 percent lower, bringing the total devaluation since Tuesday to 4.4 percent, the biggest drop in decades. We analyzed some of the possible impact of the last PBOC’s moves yesterday; however, it is worth digging further into this topic.
One of the greatest risks right now is the unwinding of the China carry trade. Years of the yuan practically pegged to the U.S. dollar led to a massive carry trade that involved investors borrowing at overseas banks at relatively low rates and then investing in higher-yielding yuan-denominated assets. However, the yuan depreciation against the U.S. dollar hits the profitability of this strategy. China has more than $1 trillion of dollar borrowing, which has suddenly become more expensive. This rise could trigger investment outflows. The carry trade has been actually unwinding for months, due to the appreciation of the greenback. The yuan devaluation may speed up this process. According to some estimates, every 1 percent of the yuan depreciation against the U.S. dollar triggers about $40 billion of outflows.
The unwinding of the China carry trade will additionally strengthen the U.S. dollar. A stronger greenback combined with weaker Chinese demand (due to more expensive imports) would mean a further commodity massacre. The strengthening dollar and lower commodity prices will definitely crush many emerging markets (there is already recession in Russia and a crisis in Latin America) due to increased debt burdens and lower export revenues. The latter factor combined with the devaluation of the yuan will exert pressure on central banks to follow with a new round of competitive easing.
What does it mean for the gold market? Well, a stronger greenback is not good news for the shiny metal. However, worries about the health of the world’s second-largest economy and whether weakness will spill over to other nations should be supportive for the price of gold. The yuan devaluation has clearly boosted safe-haven demand for gold, as its price hit a three-week high yesterday. So much for all these comments announcing that “the days of gold being a ‘safe haven’ may be over”. Nothing like that. As we have already explained, gold did not significantly response to the last phase of the Greek-debt crisis, Puerto Rico’s problems or China’s stock market crash, because investors did not believe that these risks might entail significant spillovers. However, the yuan devaluation is a different kettle of fish, since the currency markets are usually the major channel of contagion.
The take-home message is that the yuan devaluation (extended for a third day in a row) could unwind the China carry trade and significantly affect the global economy (via lower commodity prices, Chinese companies’ balance sheet problems and a stronger greenback). The portfolio rebalancing and possible financial turmoil may boost safe-haven demand for gold, especially if we see the next round of currency wars. However, the strengthening U.S. dollar would exert some downward pressure and it will take some time to change the sentiment toward gold.
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Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor
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