For markets, Brexit is not just a story of European disintegration.
The financial market stresses that could emanate from the results of the U.K. 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 U.S. 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 U.S. 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 U.S. 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 with BloombergTV, Mercatus Center Senior Research Fellow 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 U.S. dollar strength, or they add to the burden of borrowers under the parallel dollar system (or, some combination of the two).
There's "about $10 trillion dollars of loans and securities that have arisen outside the U.S., 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 hedging their U.S. dollar-denominated debt as well as Beijing's move to reference the yuan to a basket of currencies suggest a tolerance to let the yuan fall relative to the U.S. 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 Ltd., 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.
"Financial markets, for their part, appear to be tethered more closely than ever to global events, and the real economy appears to dance to the tune of global financial developments, rather than the other way round," Shin said in a recent speech. "Even a central bank that holds a large stock of foreign exchange reserves may find it difficult to head off a slowing real economy when global financial conditions tighten."
If Brexit were occurring amid a world economy that was firing on more cylinders, these potential stresses via financial markets might not be as big a deal for emerging-market economies. Alas, that is not the case.
"Global political forces continue to put downward pressure on both real trade volume and cross-border investment sentiment," writes Naufal Sanaullah, macro trader and founder of the website MacroBeat. "This does not bode well for East Asia's trade-driven economies, particularly as Chinese demand growth finds a choppy trend down."
And if Japanese policy makers wish to push back against the flight for safety that's made the yen 2016's best-performing G10 currency, such a course of action could have unintended consequences. Attempts to intervene to weaken the yen would buoy the greenback, thereby throwing fuel on neighbors' desires to devalue their currencies.
"Looking at financial markets, it is disconcerting to see RMBUSD at its lows without Yellen hawkishness, as is seeing USDJPY at new lows without much left for the BoJ to try," cautioned Sanaullah.