While the financial world has been preoccupied with Brexit since the end of last week, many investors have missed developments in China, which could be even more important in the long term.
Indeed, it emerged this week that Chinese policymakers are now open to letting the Chinese yuan fall to 6.8 against the dollar during 2016. Now this may not seem overly important at first glance, but when the yuan experienced a similar percentage decline earlier in the year, markets around the world were sent into a tailspin. At the time, many analysts cited Chinese yuan devaluation as the biggest threat to global financial stability since the great financial crisis.
Currency policy
Chinese policymakers are trying to guide the country’s currency lower, to make life easier for China citizens. Years of strong growth and capital inflows have strengthened the yuan, sending up the price of imported goods for China’s consumers.
However, by weakening the yuan China becomes more competitive on the global stage, and analysts are worried that the country could begin to steal economic growth from other nations. And as China will be able to sell its goods on the international market at a lower price relative to other currencies, prices around the world will fall adding to a deflationary headache many central bankers are trying to overcome.
All in all, by devaluing its currency China could send product prices around the world into freefall and many other countries struggling to stimulate the required growth needed to drag themselves out of recessions.
The above developments are bad news for HSBC (LSE: HSBA). It’s likely that central banks around the world will respond to China’s devaluation with further easing of monetary policy. Lower interest rates and further quantitative easing are on the cards. HSBC’s entire business model is built around interest rates, and the lower interest rates fall, the harder it will be for the bank to make a profit.
Bad news for HSBC
The traditional banking model is based on paying depositors a lower interest rate than borrowers pay. As central banks lower key interest rates, this spread between the amount paid out in interest and the amount received gets tighter and tighter. But HSBC can’t charge depositors a negative deposit rate even though central banks can push key interest rates below zero. A negative rate would lead to capital outflows and put HSBC’s balance sheet under severe strain. So, the bank has no choice but to accepter a tighter interest rate spread and falling profits.
Moreover, HSBC has traditionally invested its capital reserves in interest-yielding instruments to generate an additional return. With the majority of the highest quality bonds now yielding less than 1%, the bank is going to struggle to maintain its income stream from this strategy.
The bottom line
Overall, HSBC is facing an extremely hostile business environment. It’s evident the bank is going to struggle to find growth as interest rates plunge to lower depths. With this being the case, it might be wise for investors to give the company a wide berth. And falling earnings will put pressure on HSBC’s juicy -looking 8.3% dividend yield.
