The Renminbi’s Path Of Least Resistance

As the Chinese economy is still struggling with weak growth and heightened deflationary pressures, a weaker currency is certainly desirable in terms of aiding the authorities’ monetary easing campaign. However, it is not clear that will occur.

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Some have argued that a large one-off devaluation of the renminbi, say in the magnitude of 20%, is in the best interests of China. The 33% devaluation of the currency in 1994 has been cited as a precedent. Granted, a quick and meaningful devaluation would not only help Chinese exporters but also minimize capital flight and reset market expectations for the exchange rate. However, this option, even if economically sensible, is technically and politically not feasible in the current environment:

  • The 1994 devaluation was a fundamental reform of China’s then “dual exchange rate” system. Prior to the devaluation, the “official” exchange rate deviated massively from the prevailing market rate. In this sense, the 33% devaluation was merely a move to eliminate the discrepancy. Unlike in 1994, there is no “market-determined” level that the official fixing rate can fall to now.
  • China’s share of the world economy is currently 14%, compared with just 2% in 1994 and its contribution to global growth is even bigger. With such a hefty weight, it is a lot more difficult for China to implement a “beggar-thy-neighbor” devaluation, especially considering the weak growth profile of other major economies. Furthermore, the latest numbers show that China’s trade surplus continues to make new highs, in stark contrast to chronic trade deficits in the 1980s and early 1990s. A sharp devaluation amid a record trade surplus would inevitably invite blames of currency manipulation and bode poorly for the renminbi’s bid for the SDR.

The second option for a weaker renminbi is a series of small devaluations over an extended period of time. Please see the next Insight, (Part II) The Renminbi’s Path Of Least Resistance.

EM Versus DM: Valuation Discount Is Not Large Yet

Relative to developed markets, EM stocks are not cheap.

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EM equities appear “cheap” because the aggregate EM equity benchmark has larger weights than DM bourses in financials, energy, materials and autos, all sectors with low P/E ratios across the world.

When we control for sector weights, i.e., compare equal sector-weighted multiples between EM and developed markets, the EM discount is very small. The trailing P/E ratio for the equal-sector weighted index is 19 for EM, 21 for the U.S., 24 for the euro area and 16 for Japan.

Despite massive underperformance in recent years, EM stocks still do not yet trade at a large discount versus their DM counterparts. The valuation discount of 5%-25% (depending on the valuation ratio) is still very small given that EM credit and business cycles are in a full-fledged downturn – even while DM credit and domestic demand, though sluggish, are unlikely to contract.