The Chinese yuan has stabilized after its devaluation against the U.S. dollar in August. Our base case is that China has sufficient financial firepower to avoid an uncontrolled depreciation and/or an associated economic hard landing. However, markets should not dismiss risks surrounding the yuan and what its value implies about Chinese economic health – as well as knock-on implications for other emerging market currency regimes.
On Tuesday, China revealed that its foreign exchange reserves fell $94 billion in August alone, amid reports that it has spent roughly $150 billion defending the value of the currency. Moreover, Chinese economic data remains weak, increasing pressure on the yuan. The Chinese manufacturing purchasing managers' index for August dropped to 49.7, indicating a contraction in activity. August trade data released Tuesday showed exports decreased year on year but imports fell even more sharply, recording a 10th successive monthly decline.
Our base case is for the yuan to decline gradually by 3 percent over the next 12 months. However, even before August's decline, reserves dropped by more than $300 billion over the past year. While Chinese reserves still total over $3.5 trillion, rapid erosion would further fuel devaluation expectations, increasing the risk of larger yuan depreciation.
Since too much monetary easing might put excessive pressure on the currency, China will probably have to resort to fiscal stimulus to revitalize its economy. But in the interim, speculation over the value of the yuan could increase.
Along with low commodity prices, expectations of yuan weakness have also called some other emerging market currency regimes into question. Vietnam and Kazakhstan have already de-pegged and devalued their currencies. On the other hand, Hong Kong and Bulgaria have reaffirmed their pegs.
For now, we doubt either of the latter will abruptly abandon their currency regimes. However, it is probable that the Hong Kong dollar will eventually need to shift away from a hard peg to the U.S. dollar towards a managed, trade-weighted float, most likely involving the yuan. While we think this is still a few years away, a more rapid depreciation of the yuan would accelerate change.
We see a lower risk of devaluation in countries that have conventional pegs and predominantly export hydrocarbons, like most of the Gulf States. Their ample foreign reserves serve as the main cushion for their oil-dependent economies.
Saudi Arabia is a key example. In our base case, the kingdom has the ability and the willingness to defend the peg over the next six to 12 months. During the global financial crisis in 2008 to 2009, its central bank used 14 percent of its reserves to defend the peg amid declining oil prices. At one point, reserves fell below $400 billion. Back then, the oil price recovered relatively quickly. Today, the likelihood of devaluation would rise if oil prices remained low for an extended time and the drain on foreign reserves became unmanageable.
Currencies of countries highly dependent on commodity exports are at risk of their current account balances deteriorating, though for many countries with floating regimes, a significant currency adjustment has already taken place. Among commodity exporters with managed currency regimes, the likelihood of significant currency devaluation is probably highest in Venezuela. Hydrocarbons account for more than 95 percent of its exports and are its main source of foreign exchange. Nigeria's naira is another currency facing strong downward pressure.
Overall, investors should not assume that every emerging market currency regime that has lasted for years and, in some cases, decades will survive in its current form over a long-term or even a short-term horizon. Although China has enough ammunition to avoid this fate, markets should not regard it as completely guaranteed.
Commentary by Jorge Mariscal, the emerging markets chief investment officer at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS on Twitter @UBS.