How China's Currency Plunge Could Punish the Dow

The Dow Jones Industrials (DJINDICES: ^DJI  ) had a topsy-turvy day Friday, rising more than 100 points at one point before falling back and ending the day down 28 points. Lately, traders have been reluctant to hold on to stock positions over weekends, and that dynamic might have played a role in the late-day slide. Even as the Russia-Ukraine situation appears to reach a new equilibrium, there's an almost unprecedented situation going on in the currency markets that has some analysts watching China very closely. What's happening could have a dramatic impact on Dow components McDonald's (NYSE: MCD  ) and Caterpillar (NYSE: CAT  ) , for whom China is a key player in their growth plans, as well as the thousands of other companies looking to make the world's second-largest economy part of their expansion strategy.

The history of the yuan
For nearly a decade, China's currency has basically moved in one direction: up. With only very minor and temporary interruptions, the yuan has climbed against the dollar ever since China ended the yuan-dollar peg and allowed its currency to float on the foreign-exchange markets. From 2005 to 2008, the dollar went from buying 8.28 yuan to just 6.83 yuan -- a 17.5% drop -- and after a two-year pause during which China essentially repegged the yuan to the dollar, further declines since 2010 have brought the yuan-dollar exchange rate close to 6.

But since January, China's long yuan appreciation has reversed itself, with the currency sustaining its worst weekly loss in 20 years and losing 3% of its value. Some fear the crisis might accelerate due to financial products that are tied to certain currency levels, essentially acting as stop-loss orders that can further amplify a downward move in the yuan. When the dollar climbed above 6.2 yuan, it triggered one wave of selling, and given the number of banks throughout the Asia-Pacific region that have yuan exposure, the size of the yuan carry trade -- where investors borrow dollars to buy yuan-denominated assets in the hope that the dollar will fall against the Chinese currency -- has become monolithic.

What a falling yuan means to you
The question is whether China is allowing this to happen deliberately. On one hand, the carry trade involves huge moral hazard, as a continuous and predictable policy of yuan appreciation only encourages speculators to profit from it. Yet another reason could be that as China's economic growth slows, a weaker currency would alleviate some of the competitive disadvantages that have crept into its economy in recent years. As standards of living in China have improved, the country has faced competition from neighbors with lower labor rates, driving some of its potential business away.

For U.S. companies that have already had to deal with the impact of a strong dollar against other currencies, a falling yuan only exacerbates potential problems. McDonald's has looked to China in hopes of bolstering its overall growth, yet a dropping currency there makes its extensive Chinese revenue worth less in U.S. dollar terms. Similarly, Caterpillar's equipment sales in China have already struggled due to falling commodity prices and lower construction activity. A pricier dollar will make competition from Chinese rivals even harder for Caterpillar to fight without sacrificing margins.

If the falling yuan drives out some of the rampant speculation that has occurred in the Chinese financial markets, it would be a good thing in the long run. But for now, currency turmoil could cause short-term pain both among market speculators and companies that count on revenue from Chinese sales to drive growth.

Be smart about playing the currency markets
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