China Will Surprise in Currency War
Yuan bears are predicting August’s devaluation will be followed by an even sharper depreciation in coming months. While the market isn’t buying that yet, it’s showing some nerves.
Commonwealth Bank of Australia and Rabobank Group analysts are among those predicting China’s central bank will allow a rapid weakening of the yuan by July 2016 as it slashes benchmark interest rates to support the economy. The offshore yuan dropped 0.2% on both Thursday and Friday, while forwards contracts are flagging depreciation concerns even as the currency heads for a second month of gains in Shanghai.
The People’s Bank of China on Friday cut its benchmark for a sixth time since November after data last week showed gross domestic product grew 6.9% in the third quarter from a year earlier, the slowest pace in more than six years. Another devaluation would threaten a replay of the panic selling seen in global markets from currencies to equities that followed August 11’s surprise exchange-rate adjustment.
“If anything further monetary easing as expected should weaken the currency,” said Andy Ji, a Singapore-based strategist at Commonwealth Bank, who predicts a yuan drop of more than 3% within a few days as soon as this year. The yuan hasn’t fallen as much against the dollar as other currencies, he added, so “the offsetting effect from real appreciation renders monetary easing ineffective, especially when China is entrenched in a liquidity trap.”
Premier Li Keqiang is juggling conflicting aims of reviving the world’s second-largest economy, avoiding capital outflows and liberalising the exchange-rate regime to bolster the currency’s case to be included in the International Monetary Fund’s reserves. IMF representatives have told China that the yuan is likely to join the fund’s basket soon, according to Chinese officials with knowledge of the matter.
“The reasons for a devaluation are many and varied: the economy is underperforming, fixed exchange rates don’t allow a sufficient degree of flexibility and foreign-exchange reserves are still falling steadily,” Michael Every, head of financial markets research at Rabobank in Hong Kong, said before the PBoC rate decision. “I fail to see how they can internationalise the yuan without doing this. Right now it is artificially strong.”
Every says a devaluation raises the risk of a global currency war. Rabobank predicts the yuan will tumble 6.6% to 6.8 versus the greenback by year-end and weaken to 7.85 by the end of 2016. Capital outflows climbed to a record 194.3bn in September, exceeding the previous high of 141.7bn in August, according to a Bloomberg estimate that takes into account funds held in dollars by exporters and direct investment recipients.
The discount for three-month non-deliverable yuan forwards over the Shanghai spot price, a reflection of the outlook for currency depreciation as well as interest rates, widened to 1.25% yesterday from its post-devaluation low of 0.69% on October 7. The yuan trades 0.6% weaker in Hong Kong than in the more restricted onshore market. While that is well down from the 1.8% discount on September 7, there was a premium as recently as October 12.
The yuan’s onshore exchange rate was at 6.3505 a dollar yesterday from as weak as 6.45 on August 12, even as it was trading at 6.3924 offshore. August’s shock devaluation sent a gauge of Asian currencies to a six-year low and pushed the Standard & Poor’s 500 Index to the weakest level in 10 months. The median forecast in a Bloomberg survey is for the currency to end the year in Shanghai at 6.45.
Some investors are gaining confidence that authorities can slow yuan depreciation after a two-month fight that saw the sale of dollar reserves, stronger daily reference rates and a barrage of verbal support. There’s no basis for a sustained decline in the yuan, Premier Li told former US Treasurer Henry Paulson at a meeting on Thursday.
“I continue to see some near-term stability in the yuan” on the PBoC’s anti-speculation measures and growing expectations it will win International Monetary Fund reserve status, said Koon How Heng, a Singapore-based senior currency strategist at Credit Suisse Private Bank & Wealth Management. Even so, a growth slowdown will gradually push the yuan 3% weaker over the next 12 months, Heng said.
Gordon, a Hong Kong-based senior fund manager at Value Partners Group that oversees 14.5bn of assets, said he bought offshore yuan bonds in the past two months because yields were attractive and not because of optimism on the exchange rate.
“Many people are still skeptical or afraid of holding yuan assets,” Ip said. “The yuan will likely depreciate more over a long period of time. A sudden depreciation will definitely have a very negative impact on the sentiment, hurting credit profiles and bond prices.”
The average yield on the securities has jumped 160 basis points since the August devaluation to a record 5.97% on September 7 and was at 5.04% Friday, according to a Deutsche Bank index.
The PBoC reduced its one-year lending rate to 4.35% from 4.6%, while reserve requirements for all banks were lowered by 50 basis points. Goldman Sachs Group estimated the easing will release as much as 700bn yuan (94.5bn) into the financial system, keeping borrowing costs down at a time of record capital outflows.
The US bank predicts reserve requirements will be lowered another 50 basis points by year-end, though policy makers will seek to prevent the yuan from weakening.
Commonwealth Bank’s Ji says a more market-driven yuan will lead to “quick” currency depreciation. HSBC Holdings predicts a 2.2% decline by year-end, as the PBoC will probably stop propping up the currency after the IMF decides on its reserve basket in November.
“The next two, three years will be the most difficult for the yuan,” said Wang Ju, an HSBC strategist in Hong Kong. “As China pushes ahead with opening its capital account and eases monetary policy to stimulate the economy, the currency will keep being pressured.”
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