Market Sentiment Deteriorates Following China’s Currency Devaluation by OFR
Risk aversion intensified in August following China’s surprise renminbi (RMB) devaluation and its shift toward a more market-oriented currency regime. Uncertainty remains about the implementation of the new framework. The currency moves magnified market concerns about slowing global growth and inflation, causing pronounced sell-offs in markets for commodities, emerging market currencies, and global equities.
- China devalued its currency and announced plans to establish a more market-based currency regime.
- Commodity prices, global equities, and emerging market currencies came under significant pressure on concerns that a weakening Chinese economy could diminish global growth.
- The growth concerns and market turbulence have reduced expectations for the Federal Reserve to begin raising interest rates in coming months. The market-implied probability of a rate hike in 2015 is now about 50 percent.
- Puerto Rico’s Public Finance Corporation defaulted on an August debt payment, but with little spillover to broader municipal debt markets.
- Market concerns about Greece receded as its government reached an agreement with other euro area governments for a new financial support program.
China devalued its currency and continued policies to stem equity market declines.
China’s central bank unexpectedly announced a significant change to its foreign exchange policy. The authorities weakened the fixing rate used to determine the daily dollar-renminbi exchange rate and implemented a new mechanism for setting the rate. Citing a desire to close the gap between the official and market exchange rates, among other factors, the central bank weakened the fixing rate by nearly 5 percent against the dollar over three days and announced that the new mechanism will be based on quotes from market-makers that take into account the prior day’s market exchange rate. In response, both the onshore and offshore renminbi rates depreciated to their weakest levels since 2012. Investor demand for protection against a sharp weakening of the renminbi quickly increased, as reflected in out-of-the-money option skews (Figure 1).
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The currency move and weak economic data in China deepened concerns about the Chinese economy and its contribution to global growth, leading investors to reduce risk exposures across global markets. Global equity and commodity prices fell sharply, U.S. Treasuries rallied from safe-haven flows, andcommodity-linked currencies and Asian currencies with significant trade ties to China depreciated. Market participants perceived two motivations for the Chinese currency shift: (1) to stem downward pressure on Chinese exports and economic activity, and (2) to liberalize the exchange rate somewhat to qualify for inclusion in the basket of currencies used by the International Monetary Fund (IMF) to determine its SDR (special drawing rights) rate.
Separately, Chinese equities came undersignificant additional pressure in August. Chinese authorities have taken a number of extraordinary measures to support stock prices, but so far have had mixed results in containing market volatility. Local equity indexes are down 35-40 percent from the peak in mid-June, with sharp losses since mid-August (Figure 2). Alongside the sell-off, officially reported margin debt has declined more than 40 percent, although some market analysts report substantial margin lending not captured by the official statistics.
Some market participants have raised questions about the Chinese authorities’ commitment to liberalizing domestic financial markets following the government’s recent measures to support local equity markets. Those measures include direct and indirect stock purchases by state-owned entities, increased stock allocations for investment portfolios held by the government pension system, bans on sales by large shareholders, suspended trading of many listed shares, and allowing investors to use real estate as collateral in margin borrowing.
China slowdown fears weighed on the broader commodity complex…
Commodity prices fell sharply in recent weeks. Prices of key commodities touched multiyear lows, including those for copper, oil, gold, silver, and coal (Figure 3). Much of the rebasing in the metals and mining commodity complex has been driven bydiminished Chinese demand and increased conviction about future supply growth. Oil futures pricesapproached lows not reached since the financial crisis, with recent declines exacerbated by concerns about a global supply glut (Figure 4).
…with spillovers to other risk assets.
Emerging-market assets and other risky assets sold off, consistent with commodity price declines and downside risks to the global growth outlook. Emerging market currencies continued depreciating, with currencies sensitive to commodities and China underperforming (Figure 5). Emerging market equity indexes have fallen considerably over the last three months, with markets in Malaysia, Indonesia, Colombia, Brazil, and Turkey down 10-to-20 percent in local currency terms. At the same time, mutual fund outflows from emerging markets have accelerated, led by withdrawals from Asian equity funds, as volatility in China, low commodity prices, and weak domestic demand dampened investor sentiment.
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