For markets, Brexit is not just a story of European disintegration.
The financial market stresses that could emanate from the results of the UK referendum bear a close resemblance to what investors were worried about in the summer of 2015 and the start of 2016: the potentially unwelcome tightening in financial conditions in Asian countries. Many in the Far East, including China, operate under managed exchange rate regimes that have historically tended to rise along with the US dollar when investors seek refuge in safe havens.
These managed exchange rates have imported the greenback’s strength since the middle of 2014 as the Federal Reserve seemed poised to meaningfully diverge from the easing extravaganza of other major central banks. This development, all else equal, is a net negative for production in the domestic economies of managed exchange-rate regimes, as it encourages imports and makes exported goods less competitive.
And when the world seems to be falling apart, as was the case in the immediate aftermath of the referendum, investors tend to rush for the safety of US dollar and other haven assets.
Chinese policy makers aimed to get off this ride in August with a devaluation of the yuan, which sparked a massive sell-off in global equities. Worries about an abrupt end to the growth miracle of the world’s second-largest economy similarly rattled investors at the start of the year.
But the bout of US dollar strength in the wake of Brexit, should it continue, might mean the August devaluation of China’s currency is not a one-time event.
During an interview, George Mason University Professor David Beckworth indicated that that fallout from Brexit could spread east, as a rally in the greenback “puts a choke” on economies that operate with managed exchange rates. Either these economies import more US dollar strength, or they add to the burden of borrowers under the parallel dollar system (or, some combination of the two).
There’s “about $10tn dollars of loans and securities that have arisen outside the US, Beckworth said.”A stronger dollar makes that debt more unbearable and there’s no recourse for them; they can’t run to the federal government and they can’t run to the Fed.”
The success that Chinese corporates appear to have had in yuan to a basket of currencies suggest a tolerance to let the yuan fall relative to the US dollar, and indicate fewer worries about the ill effects that may stem from such a decline.
But indeed, in the wake of Brexit, the value of the yuan has declined relative to the greenback — though the magnitude of this move fails to measure up to what was seen in August. Moreover, measures of USDCNY’s implied volatility over the next month, six months, and year remain relatively subdued, suggesting the market is not pricing in a meaningful departure from the current policy of managed depreciation:
“China for now is doing these minor tweaks because a major devaluation (or expectations of it) would spark a massive capital outflow and financial panic,” writes Beckworth. “It would be similar to what we saw last August. I think a major devaluation is in order and I worry that Brexit uncertainty could be the catalyst that pushes the dollar high enough to cause the major devaluation.” Michael Biggs, strategist at GAM UK, suggested that a worsening in China’s foreign exchange reserves, which have been stable in recent months, could be a necessary prerequisite for the market to become worried about a step-function devaluation replacing the current policy of managed depreciation.
“The market is becoming more comfortable with how China’s managing their exchange rate,” said George Pearkes, macro strategist at Bespoke Investment Group. But as we’ve seen with Brexit, today’s complacency is tomorrow’s volatility.
Hyun Song Shin, head of research at the Bank for International Settlements, has brought attention to the extent to which capital flows have been driving foreign exchange fluctuations, and how financial markets, in turn, have set the tone for the performance of the real economy.

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