Strategy & economics
Reading the policy tea leaves in the year of the monkey
2016 is the Year of the Monkey, an animal symbolising wit and mischief in Chinese astrology. As the Chinese yuan entered the International Monetary Fund (IMF)’s Special Drawing Right (SDR) basket in November 2015, China’s monetary policy officially entered a new dimension of global influence. Since the start of 2016, the People’s Bank of China (PBoC) has lowered the onshore Chinese yuan fix (versus the US dollar) by around 1%, with the maximum daily fluctuation of just half a percent. Haunted by the “shock” devaluation in August last year, Chinese equity markets re-entered bear market territory, exacerbated by the failure of the newly-introduced circuit breaker mechanism1 and the expiration of the share sale ban for major shareholders.
We have written about the risk of further devaluation of the Chinese yuan, as well as policy errors as China opened up its financial market while wanting to remain in control. When China devalued its currency in August last year, many commentators dismissed it as a move to gain inclusion in the IMF’s SDR by displaying flexibility. However, many are now acknowledging that the Chinese authorities do want to guide the yuan to weaken versus the dollar, and that it is a regime change. This has led to two concerns: the motives behind the currency regime change and uncertainty at to the extent of yuan devaluation.
Whilst it is a consensual view that the Chinese economy is slowing, investors are worried the authorities have asymmetric information and the situation is actually much worse. While we agree that actual growth is likely to be lower than official statistics suggest, we believe the Chinese authorities have the capacity to prevent a hard-landing given their massive (although declining) foreign reserves, and their ability to direct liquidity to problem areas when needed. After an appreciation of more than 30% in the real effective exchange rate2 of the yuan over the past five years, the desire to weaken the yuan is a justified alignment, with weaker economic fundamentals and the sharp depreciation in currencies of China’s key trading partners.
From a stability perspective, we think a sharp one-off devaluation of the yuan is unlikely. Such a move would provoke an even more aggressive reaction from other emerging countries and would provide little help to exports. More importantly, it would further destabilise the stock market and domestic sentiment. We believe stability is the most important agenda item for the Chinese authorities and no official will want to take responsibility for a free-fall in the yuan (say, over 10%). In fact, the heavy intervention in the offshore market to prevent speculation against the yuan is a good indication that the authorities have no appetite to see the yuan depreciate too much or too fast.
Based on our view of the authorities’ desire to bring the yuan in line with deteriorating economic fundamentals and a preference for stability, we expect gradual yuan depreciation of up to 5% versus the US dollar in 2016, with long lags in between new fixes. It is worth noting that it implies the Chinese yuan will be roughly stable on a trade-weighted basis. We think the Chinese authorities can manage a gradual pace of devaluation, despite the potential drain in reserves, as they still have control over the flow of capital and room to cut the reserve requirement ratio sizeably to maintain domestic liquidity.
Taking a step back, a 1% daily move or 5-10% move over a period is not unusual for the US dollar, euro or Japanese yen. The reason why the modest yuan devaluation is creating such a significant impact is due to poor communication from the authorities. It will be much better if the Chinese authorities can signal their intention to devalue the yuan by a certain percentage, instead of leaving markets to guess. Unfortunately, we still have the policymakers and regulators in China who lack the experience or finesse of those in the West. So, it would be unwise to expect their communication skills to change overnight.
Having said that the PBoC is sending an increasingly clear message that the central bank will manage the direction of the yuan versus a basket of currencies, instead of only the US dollar, and that two-way volatility is inevitable during the process. We think the markets have started to gain more understanding of the new currency regime and will be less unnerved by subsequent moves by the PBoC.
While China is often being cited as the biggest risk for financial markets, uncertainty and confusion over monetary policy from the ‘big four’ central banks (the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan) will also contribute to a more difficult environment for investment in 2016. We expect to see a “four-way split”, involving varying degrees of monetary policy divergence from the four central banks.
Past performance is not a guide to future performance.
In the US, although the Federal Reserve (the Fed) has begun to tighten policy,
it will likely be reluctant to raise interest rates again in March unless current market volatility diminishes. Furthermore, it seems unlikely that we will see the four interest rate increases implied by the Fed’s policy guidance for 2016. For the UK, we believe the Bank of England will delay an interest rate increase to the latter part of 2016 as the Monetary Policy Committee has demonstrated continued reluctance to normalise policy – irrespective of economic fundamentals. For the eurozone, the chance of further easing from the European Central Bank has risen, as the governing council has expressed more concern over external risks and, potentially, a much lower inflation profile. However, there is room for disappointment again, given elevated market expectations. And finally, in Japan, the Bank of Japan (BOJ) has surprised markets by introducing negative interest rates as an additional policy tool, to complement its vast quantitative and qualitative easing (QQE) programme. The move suggests the BOJ is approaching its limit with regard to QQE, and is now having to resort to more technical changes – even though they are unpopular, distortionary and may not have the desired effect.
Past performance is not a guide to future performance.
The synchronised and large-scale quantitative easing measures by the ‘big four’ central banks now lie in the past, largely because Western economies are no longer in crisis. This implies monetary policy will be more disparate, technical and uncertain going forward, potentially causing greater market volatility. The only certainty against this uncertain backdrop is that much vigilance will be needed to negotiate successfully the volatility that the Year of the Monkey seems set to bring.
1 Under the circuit breaker mechanism, the market will be suspended for 15 minutes when the market index declines by 5% and closed for the rest of the day if the index declines by 7%.
2 Definition of ‘REER’: the weighted average of a country’s currency relative to an index or basket of other major currencies adjusted for the effects of inflation.
3 The Bank of Japan will adopt a three-tier system in which the outstanding balance of each financial institution's current account at the Bank will be divided into three tiers, to each of which a positive interest rate, a zero interest rate, or a negative interest rate will be applied, respectively.
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