iFund- The impacts of currency depreciation

2019-08-12 06:32
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The recent depreciation of the Renminbi and the "breaking of the seven" have triggered numerous discussions in the market. The most common question is what benefits will be brought about by currency depreciation?

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The recent depreciation of the Renminbi and the “breaking of the seven” have triggered numerous discussions in the market. The most common question is what benefits will be brought about by currency depreciation? One general answer is that currency depreciation will help improve export competitiveness. Generally speaking, international trade between non-US dollar economies is mostly paid and settled in US dollars. Currency depreciation will give exporters and producers more bargaining space to gain an advantage in quoting, thus obtaining more orders, but ultimately It is also necessary to consider other costs, such as whether imported raw materials and labor costs have risen due to currency depreciation. As such, this is not a simple one plus one problem. Different industries will have a different degree of benefits too.

On the other hand, currency depreciation will likely curb demand for imported products. The price of foreign imports in domestic currency has increased due to currency depreciation, which may eventually affect demand as customers shift to local substitute products. Besides, currency deprecation may add inflation pressure to importing economies too, especially for countries that rely heavily on essentials and food imports. Overall, currency devaluation mostly helps to improve the trade deficit of the devaluation countries and restore the balance of payments imbalance. For China, the recent depreciation of the renminbi against the US dollar will likely further expand China’s trade surplus with the US. However, the US will likely take more drastic retaliatory measures on this.

Another issue that investors are more concerned about is the impacts of currency depreciation to individual sectors and companies. Apart from the exporting enterprises, currency depreciation could have positive impacts to large multinational listed companies, especially for those whose main business and revenue source is generated from foreign markets. One is that currency depreciation will likely increase their consolidated income and earnings (in local currency), while at the same time for companies with most debt in local currency will have a relatively less burden for their interest expense payment. Therefore, currency depreciation could be a positive catalyst, assuming the reporting currency is the local currency for these companies. Of course, one argument is that some of them will hedge for currency risk and may not benefit from currency deprecation at all. However, considering that hedging cost is actually expensive, most listed companies will not fully hedge their currency exchange rate risks.

In contrast, companies that focus on local businesses but whose main costs or raw materials are settled in foreign currencies will have a negative impact on currency depreciation. In particular, those in a more competitive industry, such as airlines (fuels are settled in US dollars, passengers are mainly local, but the industry is fiercely competitive, and passengers are price-sensitive) are usually failed to raise prices fully to offset the rising costs. Eventually, these companies may have lower gross margin and earnings due to currency depreciation. Likewise, local companies whose debt is mainly in foreign currency (possibly attracted by the lower foreign debt rate) and with a net liability exposure (total liabilities > assets) will be benefited from currency depreciation on reducing interest expenses or principal repayment.

In conclusion, currency depreciation generally favors export trade. However, its impact has become more and more difficult to predict due to increasing globalization. Besides, other countries may also vie for depreciation and ultimately cause risks such as global currency war. In addition, excessive currency depreciation may also lead to capital flight and asset bubbles. Therefore, currency depreciation is actually a double-edged sword.

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