It is déjà vu all over again for the financial markets. The events of August 2015 are being repeated with China’s stock market collapsing like a house of cards, its currency — the yuan — reeling lower and other global currencies and stock markets quivering.

In August last year, there was a scare that China was embarking on a path of rapid ‘devaluation’ of its currency, which could lead to competitive devaluation of other currencies. But despite the 6-per cent slide in the yuan since then, the currency is far stronger compared to other emerging market currencies, such as the real or the rouble.

That said, this is a period of adjustment for the yuan as the currency shifts towards a more market-linked trading. It is quite possible that the yuan heads lower in the days to come and this has implications for the rest of the world. India could, however, benefit as foreign investors may re-allocate some of their investments from China into India. The Chinese currency was linked to the market by the People’s Bank of China last August, by pegging the opening value of the yuan in every session to the previous day’s closing rate, the demand and supply condition in the foreign exchange market and the movement of other currencies. The yuan was then allowed to move in a band of +/- 2 per cent from this reference rate. The move to market-link the yuan was to enable the Chinese currency become part of the SDR basket of the IMF. With the inclusion of the yuan in this basket since November, the Government of China will now have to allow market forces to wield a greater influence on the currency’s movements.

Weak numbers Weak manufacturing data and numbers showing that foreign investors are pulling money out of China have resulted in sentiment turning quite adverse towards the yuan of late. Value of the yuan traded in offshore markets began sliding sharply lower, implying that the currency was being artificially pegged higher in the onshore spot market. The Government of China pegged the yuan reference rate lower by 0.5 per cent on Thursday, the largest adjustment since last August, triggering a major panic in currency markets. The sharp fall in China’s forex reserves from close to $4 trillion in June 2014 to $3.3 trillion in December too shows that there is a limit to the extent to which the government can support the currency.

It is obvious that the Government of China will now have to bow to market forces and restrain its intervention in the currency markets. There is room for the yuan to depreciate further against the dollar since the Real Effective Exchange Rate of the yuan shows that it is overvalued by over 30 per cent.

If the Chinese currency is going to slide lower, there will be a major impact on global trade as Chinese exports get cheaper. China’s borrowings in dollars will be impacted as they will have to repay higher amounts. Foreign investors in Chinese stocks too will have to re-think their strategies.

Investors in stocks Foreign investors have largely avoided China’s A shares that are traded on the Shanghai and Shenzhen stock exchanges and are quoted in yuan, and have preferred to invest in Chinese stocks through the H shares listed in Hong Kong, thus reducing the risk arising through yuan movement. But if the controls on the yuan are gradually lifted, the Hong Kong dollar might become irrelevant and foreign investors might no longer have the option of buying Chinese stocks, sans yuan risk. Higher currency volatility can make Chinese equity less attractive.

Two, the prices of H shares are linked to the shares traded in Shanghai and Shenzhen. The ongoing bedlam in those exchanges with retail investors hitting the panic button and dumping shares highlights the systemic risk in this market. Foreign investors have been pulling money out of China and these outflows can accelerate if the equity market rout continues.

India’s gain While it cannot be said that the money that is currently moving out of China will flow into the Indian stock markets immediately, since rising risk aversion will initially result in outflows from all emerging markets, over the long run, India is likely to benefit.

Many global emerging market funds have the largest portion of their investments in China with India featuring slightly lower in the list.

For instance, IShares MSCI Emerging Market fund invests 21 per cent of its funds in Chinese stocks and 9 per cent in India. Similarly, the Vanguard FTSE Emerging Market Fund has invested 22 per cent in China and 13 per cent in India. The ongoing turbulence can make China’s share move lower, and can work to India’s advantage.

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