We are more bearish on the yuan as we expect the Chinese authorities to weaken the reference rate to support economic growth. A weaker exchange rate will also support inflation and industrial profits growth, which are declining. A wider yuan trading band could be announced as soon as the second quarter of this year if market conditions are conducive. We maintain our view that the yuan will remain relatively resilient against the background of broad-based dollar strength due to other positive attributes.
More bearish on the Chinese yuan
We have become negative on the outlook for China’s yuan and have adjusted our USD/CNH 2015 and 2016 year-end target to 6.35 (from 6.27) and 6.45 (from 6.35) as recent economic data have disappointed. First, we expect the Chinese authorities to allow a weaker onshore yuan (CNY) reference rate to support the economy. Second we expect the currency trading band to widen this year and the CNY to trade on the weaker side of the trading band. Last but not least, the offshore yuan (CNH) is likely to trade at a discount to the CNY due to diverging economic and monetary policy trends between China and the US.
Weaker exchange rate to support economic growth…
Economic growth has been trending lower in the past few years, in line with the Chinese authorities intent for the economy to grow at a slower but more sustainable rate. Since the yuan was made more flexible in the middle of 2010, the yuan has appreciated by almost 20% against its trade weighted basket of currencies. Although the yuan declined by more than 2% against the US dollar last year, it outperformed its trade weighted basket of currencies by more than 5%. In our view, the currency is no longer undervalued. Indeed industrial profits growth has declined from 11.7%yoy in July to 3.3%yoy in December last year, the slowest pace of growth since 2012. Hence a weaker exchange rate would be a welcome support to the export sector and industrial sectors.
…and mitigate disinflationary pressures
The strong yuan and slower economic growth is exerting downward pressure on inflationary pressures which is 2.7 percentage points (January 2015 inflation was 0.8% yoy) below the central bank’s 3.5% target. Disinflationary pressures are expected to persist as the full effects of lower oil prices filter through the economy. A weaker exchange rate will help to mitigate the slide in inflation.
Wider CNY trading band likely in 2015
We think that the People’s Bank of China may widen the Chinese yuan (CNY) trading band to +/-3% as soon as the second quarter of this year. This would allow a more flexible exchange rate ahead of IMF review to include the yuan in the Special Drawing Rights (SDR) basket later this year. Furthermore we note that in the past, the trading band has been widened when economic growth was below the trend rate (2011-2014) of 1.9% qoq. Growth was disappointing at 1.5% qoq in the last quarter of 2014 and we expect headwinds to the economy to persist in the current quarter.
Conditions conducive for trading band to be widened
In our view volatility and sentiment in the yuan are crucial. The PBoC has stated several times that its preference is for a stable exchange rate. Hence it is unlikely that the trading band will be widened during periods of high volatility in currency markets. Sentiment in the yuan has also been weak with the onshore rate trading near the weaker limit of the 2% trading band since the middle of January this year. This is due to expectations that economic growth and interest rate differentials between China and the US will narrow further this year.
We suspect that the central bank has been defending weakness in the yuan in recent weeks to stabilise the yuan. We note that in past cases, the trading band was widened during periods when the yuan is not trading at the weaker limit of the trading band. This is probably due to concerns that widening the trading band when market sentiment in the yuan is extremely bearish will exacerbate greater volatility in the currency. We think that the current priority of Chinese authorities is to stabilize economic growth through other monetary tools like reserve requirement ratio cuts and/or cuts in lending rates.
Wider trading band implies weaker exchange rate?
It depends. A wider trading band basically allows greater fluctuations in the exchange rate as determined by market forces. The PBoC is still able to influence the direction in the yuan via the daily reference rate. We note that the daily reference rate has been used previously to lean against market forces when the direction in the yuan is deemed inconsistent with economic fundamentals and/or during periods when market sentiment was extreme.
In 2014, the yuan reference rate was allowed to weaken by around 0.3%. Given slower economic growth and increasing disinflationary pressures, we think that the yuan reference rate could be allowed to weaken more this year. Sentiment in the yuan is also likely to remain on the weaker side of the trading band due to diverging economic and monetary policy trends between China and the US. Hence in this case, a wider trading band will provide more flexibility for the yuan to weaken further.
Nevertheless the Chinese yuan to remain resilient
The yuan is expected to remain resilient as lower oil and commodity prices will improve the trade balance. Sentiment in the yuan should also improve as economic growth stabilize in the coming months. In addition, the PBoC has large foreign currency reserves to defend volatility and weakness in the yuan that is inconsistent with economic fundamentals. Increasing market demand for the yuan as a trade settlement and reserve currency will also provide a stable flow of demand for the yuan.