China recently elected to devalue their currency causing volatility in most global markets. One benefit of this event was that it removed Greece from the headlines. Although our belief was that too much attention was being placed on Greece and its implications for the European Union, it was welcome to see it move to a page two story.

The three percent devaluation of the Chinese Renminbi (RMB) represents a material event that could have lasting ramifications. With the economic slowdown impacting China, the media quickly jumped to the conclusion that this devaluation was China’s way of joining the “currency wars”. China’s economy has historically benefited from exports, and a cheaper currency would be a welcome sight for a sluggish economic environment. However, the size of the devaluation is not the real story from our perspective. China represents the second largest global economy, yet it is still highly insulated from the world. It has a centrally managed political system that attempts to controls market interactions. The devaluation of the currency was much less about the magnitude of the change and much more about allowing the currency exchange rate be determined by the market (to some extent) rather than by the government. Allowing the market to have a say in the value of the RMB will likely be felt by many in the region.

Currencies are highly complex instruments that can become confusing due to their interconnectedness. We find it helpful to look at currencies similar to commodities. They can be mined (printed) like iron ore, refined (invested into higher return opportunities) like oil, stored (saved) like gold, and consumed (poorly invested) like grains. Similar to commodities, the value of a currency is not static. Values will change based on the supply and demand environment. That is unless its value is controlled by the country’s government. As an example in markets free of intervention, when U.S. consumers are spending increasing amounts on imported goods, dollars flow overseas in larger sums. This increases the supply of U.S. dollars in foreign markets thereby lowering the price of the dollat relative to other currencies. Conversely, if U.S. consumption of imports is declining, dollars outside the U.S. become harder to find and therefore more expensive. All of this is assuming the demand for dollars doesn’t change.

Up until this past week, the People’s Bank of China (the Chinese version of the U.S. Federal Reserve) controlled the exchange rate of the RMB thereby preventing market participants from experiencing its inherent value. Their historic desire to be linked to the world’s largest reserve currency advantaged them as they built out their economy. It is now, however, becoming a hindrance. China’s drive to become a global superpower will be limited unless it can increase the influence of its financial markets.

Developing China’s currency into global currency is of upmost importance for China’s continued growth. The best way to have that occur is to have it be accepted as a global reserve currency. The distinction of becoming a reserve currency is more than just a badge of honor. It provides a presence in the world that demands acceptance and also results in lower borrowing costs. The decision of who joins this elite club is in the hands of the International Monetary Fund (IMF). The IMF has two criteria that need to be met before they will expand the membership: (i) a sizable amount of global trade transacted in the currency, and (ii) the currency must be easily exchanged into other reserve currencies. The RMB easily meets the first criteria as China is the third largest trading partner in the world and has shown an ability to have trade transacted in their currency. The IMF has been critical of China as it pertains to the second major criteria; the ability to be easily exchanged. The IMF has been vocal that China will need to open up their markets, especially their currency market, if they want to obtain the coveted spot as a reserve currency. The move last week was a critical move in that direction.

The implications of the devaluation will have far reaching effects. Similar to anytime that a controlled environment becomes open to public scrutiny, things will change. With the devaluation being a current event, it will be hard to have great confidence in any of the predictions. There are two prediction, however, that seem likely to us at this time; commodities and emerging Asian markets will likely suffer.
Until the recent devaluation, China pegged its currency to the U.S. Dollar. The U.S dollar has seen significant strengthening relative to the other major currencies. With the partial release of this peg, markets will likely want to depreciate the RMB value relative to the dollar. The likely impact will be a turbulent and strong dollar relative to China’s RMB.

Although both emerging markets and commodities have seen recent weakness as a result of many factors, the added weight of a strong dollar will present new challenges. For emerging economies in Asia, the added competitiveness of China’s weakened currency will hurt their export markets. This is in conjunction with their recent economic policies that have built up the largest amount of dollar denominated debt since the Asian currency crisis of the late 1990’s. For commodities such as oil, which is priced around the globe in U.S. dollars, a stronger dollar will add to the price depreciation.

The Auour investment decisions have been on the correct side of both of these trends. When we repositioned portfolios in late July we lessened our exposure to both emerging markets and to industries tied to commodities. We continue to monitor the actions in the global markets and, at least for now, maintain a fully-invested stance that targets higher-quality, developed-market securities.