China's currency conundrum: Cause for alarm?

Markets started 2016 in chaos: It was the worst start for the S&P 500 and the Dow Jones industrial average ever.

Global stocks had their worst drop in more than four years, down more than 6 per cent for the week.

A lot of it comes back to red alerts about China's currency and what policymakers are trying to do.

But is it justified?

A growing chorus of economists and currency strategists suggests the weakness in the yuan may not be as scary as some believe.

A chief worry in the market is the seemingly huge scope of the move. But, in actuality, it's relatively small by historical standards.

Brown Brothers Harriman Chief Currency Strategist Marc Chandler notes that China's currency is actually significantly stronger over the course of the last decade, and the recent moves are a relative blip.

"The big picture here is the Chinese yuan strengthened 50 per cent in its broad trade-weighted index since 2005. It has gained about 30 per cent since early 2011 and has now recouped 4 percentage points," he said.

In fact, the 1.5 per cent weakening of the yuan last week paled in comparison with moves in other currencies. Australia's dollar and New Zealand's kiwi lost more than 4 per cent each. South Africa's rand has lost 8 per cent of its value this year.

A second major concern: China is weakening its currency to help exporters and spark its economy. But, the damage and destruction of the policy on global markets and economies may make the strategy seem fruitless.

"The currency devaluation is meant to spur Chinese growth, but if the devaluation shocks European and US markets to the point that it triggers extreme risk aversion and possibly recessions there - then it is counterproductive," Peter Tchir, head of macro strategy at Brean Capital, wrote in a note Sunday.

"It seems like [what] all the global stock markets and economies can digest in a short time is 4 to 5 per cent [drop in the currency]," Tchir wrote.

In other words, the ripple effects caused by China's policy moves may force Beijing to weaken less than quickly and less aggressively than planned.

"My bottom line remains that gradual, further depreciation of the renminbi is the most likely outcome, maybe for another five to 10 per cent to help stimulate the economy, but nothing more dramatic," wrote Erik Nielsen, global chief economist at UniCredit, in a note on Sunday.

Another concern investors have about China's weakening currency: It will reignite a regional currency war, but so far, China's currency is primarily weakening against the U.S dollar, and Asian currencies are already weakening on their own.

 "At the moment the yuan is weakening against the dollar but is remaining broadly stable relative to the PBOC's basket [of other currencies]," said Kit Juckes, senior currency strategist at Societe Generale, referring to the People's Bank of China.

Economists and strategist worry that China's devaluation will spark trading partners such as South Korea, Indonesia, Malaysia and Taiwan to intervene in order to weaken their own currencies, to boost their own export competitiveness and gain an edge against China in global trade.

China's "actions will flame the currency war in the region," said Kathy Lien of BK Asset Management.

However, Asian currencies have been weakening for the past two years, and the first week of 2016 was no exception.

South Korea's won fell double the amount of the yuan last week, down more than 3 per cent of the year. Most Asian currencies including the Malaysian ringgit, Taiwan's dollar and Indonesian rupiah fell, with the notable exception of the safe haven Japanese yen.

Since Asian currencies are already weakening on their own, there may be less official central bank intervention and competitive "beggar thy neighbour" policies, which end up hurting growth and trade.

So far, all of this assumes China is in control and is trying to steer its currency sharply weaker to help boost its economy with exports. But there's another lurking suspicion that China is in fact not in control of this currency move at all.

There's a deep concern among investors that the yuan's drop is being driven by the market and a flood of money being yanked out of a slowing Chinese economy.

Last week, we learned that China's reserves fell by a record $108 billion in December, which signals the central bank is spending a lot of money to actually prop up the currency so it doesn't collapse under the wave of outflows.

It's a scarier prospect than the concerns about China's growth and exports.

However, in reality, strategists say the outflows may be short-lived and the policy response could very well inspire confidence instead of desperation.

Why?

For one, "it is typical in this time of year to have a seasonal outflows. Corporations front load their hedging for the year," according to Maher.

As for the question about confidence in policymakers' ability to control outflows and the currency, HSBC Holdings currency strategist Daragh Maher points out that the depreciation shows China's authorities are actually making good on promises to allow their currency to be more driven by market forces.

China has promised repeatedly to let its currency move to a more free-floating, less managed and controlled beast. It's something investors and policymakers around the world want to see.

"I would say investors should have faith in Chinese policymakers because they've been fairly consistent," Maher said.

Of course, if the reserves continue to plummet and outflows pick up, there will be bigger concerns about the impact. For now, Maher and others are taking the moves as a signal that China is increasingly letting its currency be dictated by the market.

The bottom line: China's currency remains an enigma. So when you have sharp reversals of multiyear trends like we've seen, investors are guessing and speculating and stressing about why it's happening, what is says about the economy and what it means for others.

But so far, there's plenty of reasons to remain calm.