Strategy & economics
Chinese yuan fix-as-you-go
Exchange rate reform à la beijing style and its implications
In our March commentary, we presented our “3D” view of China in 2015: disinflation, devaluation and de-synchronisation. So far, the developments in China have played out as we expected. On August 11th, the People’s Bank of China (PBoC) lifted the daily USD/CNY (price of 1 US dollar in Chinese yuan) exchange rate fixing by 1.86%. Going forward, the daily Chinese yuan (CNY) fixing will be based on the closing market exchange rate of the previous trading day, demand and supply conditions, and the movements of major international currencies.
This decision caused significant disruption in financial markets and has prompted considerable speculation with regard to the ‘true’ reason behind this change. Is China moving toward a market-based exchange rate merely to support its bid to be conferred with the International Monetary Fund’s (IMF) reserve asset status? If so, what determined the timing and what is the likely future trajectory of CNY?
We believe China’s exchange rate regime is likely to be “Fix-As-You-Go” at PBoC’s desired pace: the direction the yuan takes will depend on economic data, what the US Federal Reserve (the Fed) does to interest rates, and whether the PBoC judges the trend to be China’s friend.
The crouching tiger stretches its claws
We have coined the term “Fix-As-You-Go” to describe our expectations about how the yuan will fit into the PBoC’s overall policy stance. The big picture is all about the economy. Despite a range of fiscal and monetary easing measures, growth prospects in China have continued to deteriorate. In particular, the latest round of data releases point to a sharp fall in exports, steeper decline in producer prices and disappointing industrial production. While weak global trade, a slump in commodity prices and structural changes in the Chinese economy are contributory factors, a strong currency has significantly eroded China’s competitiveness over recent years.
Taking into account the effect of inflation, the real effective exchange rate (REER)* of the yuan has risen sharply. According to data from the Bank of International Settlements (BIS), the yuan’s REER has risen +30.4% over the past five years, compared to +9.1% for the US dollar, -7.71% for the euro and -33.7% for the Japanese yen. It is the same story for the yuan’s REER relative to other emerging Asian currencies, whose economies China both competes with and exports to. It is not hard to imagine the difficulties of Chinese manufacturers and exporters over the past five years. If US exporters are fretting over challenges from a strengthening US dollar, then Chinese exporters have suffered a magnitude more. So, at the very least, it would appear that the timing of the change in currency policy reflects growing concern over the economic damage being inflicted by the appreciation in the yuan. That damage would become greater were the US dollar to appreciate, consequent on a tightening in monetary policy by the Fed later this year. In our view, the Chinese are not engaging in competitive devaluation. They are simply guiding the currency toward what the authorities believe are fairer levels, and in line with market forces and economic fundamentals.
CNY “Fix-As-You-Go” is the way to go
To form a view on whether devaluation in the yuan will prove a one-off, it is necessary to try to read the policy tealeaves. In its latest briefing, the PBoC said it intends to keep the yuan stable at an equilibrium level, while monitoring the balance of payments, domestic economic fundamentals and effective exchange rates. Taking the comment at face value, the authorities’ desired equilibrium level of yuan is probably lower than the current one, for the economic reasons already described. Our view is that while the yuan can potentially depreciate by as much as 10% in a year, it will be done in a stepwise fashion. The PBoC is unlikely to want to engineer too sharp a devaluation, for fear that this would become destabilising and could spark capital flight. It also understands that a prolonged period of gradual devaluation could cause such expectations in relation to future movements to become entrenched, again leading to capital outflow.
Hence, the path of yuan devaluation will likely be gradual, with potentially quite long periods between steps; it is also likely to be data-dependent. The question of whether China is taking a reformist approach to its exchange rate policy is very much open to debate. True, the new approach to yuan fixing is structured to be market-driven. But it is evident that persistent intervention in the onshore trading market is likely, given a probable desire to smooth volatility and prevent excessive devaluation. In our view, Beijing’s capital market reforms usually progresses when the underlying trend is on its side; to this extent, the true desire to reform lacks a degree of credibility. In fact, we argue that China’s policy approach to capital markets risks holding back genuine reforms. For instance, the State Administration of Foreign Exchange (SAFE) will likely tighten its control over foreign currency transactions, potentially delaying the progress of capital account liberalisation. The interventionist approach to supporting the local stock markets, including banning the sale of certain stocks, is another good example of the state wanting to remain able to manipulate financial markets in a desired direction.
Impact on China
Given that China’s REER has appreciated by +30% in the past five years, a few percentage points of devaluation is unlikely to revive exports. This suggests that we are likely to see further managed depreciation. In the yuan “Fix-As-You-Go” regime, we see the PBoC using the exchange rate as an additional policy tool to underpin growth. Heightened risk of capital outflow will probably prompt further cuts to the reserve requirement ratio (RRR) to improve liquidity. Nonetheless, our view is that China’s growth will continue to disappoint despite accommodative policies, as sporadic easing measures are insufficient to counter structural slowdown. Meanwhile, there is a growing probability of delay on genuine reforms and also of policy errors.
Impact on emerging markets
Emerging markets (EM) are likely to feel the most pain from China’s currency adjustment. As the PBoC has a track record of surprising markets and implementing policies without warning, we expect heightened volatility in the yuan. The transition to lower currency levels will likely result in increased uncertainty and may exert downwards pressure across the EM currency spectrum, especially those with significant trade links to China. From this perspective, the Korean won, Taiwanese dollar, Brazilian real, etcetera are likely to become more fragile. We have already seen a knock-on effect in the region’s other currencies, accentuated by the impending policy normalisation by the Fed. To a large extent, this reflects the fact that Chinese exports to the US, UK and Eurozone are much less significant than those to Asia Pacific.
Impact on commodities
Since China is one of the world’s major users of commodities, prices often denominated in US dollars, will face further headwinds as these commodities will cost more to buy in yuan terms. From a supply perspective, yuan depreciation will be the most negative for commodities of which China is both a significant producer and exporter, such as aluminium and steel. We believe prices of industrial metals will face further downside pressure from declining demand and rising exports from China. As a result, commodity exporters’ growth will remain dull and their currencies will likely struggle.
Impact on developed markets’ inflation and monetary policy
Weak commodity prices have already contributed to low headline inflation globally. It is worth assessing the impact of further yuan depreciation on inflation in developed markets, given the impact this could have on US monetary policy. Using an econometric model, we have assessed the impact of a 10% fall in the yuan over one year on the US Consumer Price Index (CPI). The model suggests that the US CPI would be at most 0.2% lower after a year, compared to the scenario of a stable yuan. While we acknowledge that heightened uncertainty and risk of currency instability in emerging markets could delay an interest rate increase by the Fed, worries about the disinflationary impact of yuan depreciation on developed economies is overdone. Hence, we do not believe that the Fed will be unduly concerned by recent developments and it remains on track to raise interest rates by the end of 2015 as domestic activity strengthens and services-generated inflation rises.
The reaction in financial markets to the uncertainty caused by China’s latest actions was swift. Equity markets fell sharply and bonds rallied, making the latter even more over-valued. Once the Fed has initiated the anticipated policy tightening, government bond yields are likely to resume their upward grind. As I previously mentioned, we think the concern on developed markets’ exposure to China is overdone, which opens up pockets of value in developed market equities, excluding commodity-related sectors. We remain cautious on emerging markets, as it is evident that commodity producers and manufactured goods exporters, alike, are still struggling to adapt to the post-recession world economic environment which remains characterised by much lower Western growth.
*The weighted average of a country's currency relative to a basket of other major currencies, adjusted for the effects of inflation.
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