- The PBoC’s recent adjustments to the exchange rate regime have caused quite some market turmoil worldwide.
- Still, they make sense as the de facto CNY peg to the strong USD was hurting competitiveness and not sustainable.
- We also think the authorities want to show commitment regarding liberalisation, with a view to the IMF’s SDR decision.
- We expect some more currency weakness, although the authorities will be constrained by several stability concerns.
- The moves help to support and reinflate the economy, but we expect easing to be stepped up should growth deteriorate.
PBoC adjusts fixing rate, triggering depreciation
After having tied the Chinese yuan closely to the US dollar since March, the PBoC surprised markets this week by adjusting the USDCNY fixing by a cumulative 4.7% from 11-13 August. This adjustment triggered a 3.5% depreciation of the yuan versus the US dollar so far. These developments had quite an impact on global financial markets, leading to weakening equities and Asian currencies, but supporting Treasuries and Bunds.
Regime shift a step to restoring external competitiveness
In our view, the PBoC’s surprising twist serves two policy goals. The authorities try to support and reinflate the economy by preserving export competitiveness. The poor export performance this year (with exports falling by 8.3% yoy in July) partly reflects the real effective appreciation of the CNY, which had been de facto tied to the USD since March. The CNY has become particularly strong vis-à-vis the JPY and the EUR, reflecting the BoJ’s and ECB’s unconventional QE policies. Exports to Japan and the EU contracted by 13% and 12.3% yoy in July. The real effective exchange rate has risen by almost 10% since the start of last year. Against that background, ending the peg to the USD, currently one of the strongest currencies worldwide, looks quite prudent.
… and to show some commitment on liberalisation …
Another main goal is to show commitment to further currency liberalisation in the run-up to the IMF’s decision on RMB inclusion into the SDR basket. The IMF recently indicated that further liberalisation is needed, while hinting to postpone the SDR decision to 2016. After the authorities had already announced financial liberalisation measures in early 2015, they now show their preparedness to make the exchange regime more flexible. Still, recent developments on the stock market are a reminder of the fact that liberalisation efforts in China often comes in the form of ‘two steps forward, one step back’. Sometimes, the authorities come with short-term stabilisation measures, running counter to longer-term reform goals.
… but there are also constraints
Meanwhile, the PBoC also faces constraints. The ‘stability-oriented’ authorities will likely not tolerate too much CNY weakness, as that may trigger more capital outflows and would raise the repayment burden of entities with high USD-denominated debts. It is quite early to assess how the authorities will weigh goals and constraints going forward. Taking into account the latest developments, we have changed our yuan forecasts to 6.55 per end-2015 and 6.75 per end-2016 (for more detail, see today’s EM FX Weekly).
Imports remain in contraction mode too
Imports remained in contraction mode for the 9th consecutive month, falling by 8.1% yoy. While this weak number highlights domestic demand issues, lower commodity prices have once more affected import values too. Still, CNY weakening could be yet another factor in preventing Chinese imports from recovering. Meanwhile, China’s trade surpluses remain very high. Although capital outflows have risen since late 2014, we are still of the view that China’s external position is strong given its external surpluses and huge FX reserves covering 1.5 year of imports and total external debt fully.
July activity data disappoint
Recent activity data point to ongoing weakness, particularly within the industrial sectors. Industrial production slowed to 6.0% yoy in July (June 6.8%). So did fixed investment and retail sales, although marginally. After rebounding to 6.9% yoy in June, Bloomberg’s monthly GDP estimate dropped to 6.6% in July. The manufacturing PMIs published in early August also pointed to industrial weakness, with Caixin’s index falling to a two-year low of 47.8. Meanwhile, the services PMIs still show resilience, highlighting the ongoing divergence between a struggling manufacturing and healthy services sectors.
PPI keeps falling, other inflation numbers less concerning
Meanwhile, the latest inflation data presented a mixed bag. The most eye-catching number was the further drop of producer price inflation (for the 41st consecutive month), falling to a six-year low of -5.4% yoy (June -4.8%). While this clearly highlights the weakness of China’s industrial sectors, faced with oversupply, low commodity prices certainly also played a role in pushing PPI even more into the red. Other inflation numbers for July were less dramatic. Headline inflation rose to a 9-month high of 1.6% yoy (June 1.4%), helped by rising pork prices. Core inflation remained stable at 1.7% yoy. Finally, house prices seem to have bottomed out, as recent policy initiatives have led to improving sales and construction activity in the real estate sector, at least in the largest cities.
New loans surge on stock market measures
The latest lending data also showed a mixed picture. New yuan loans jumped to a 6.5 year high of CNY 1.48 tn, breaking with seasonal patterns. Growth of M2 rose to a one-year high of 13.3% yoy (June: 11.8%). However, this acceleration was mainly driven by the actions taken in June and July to stabilise the stock market, causing lending to non-bank financial institutions (including China Securities Financing Operation) to surge. New lending to corporates and households actually fell in July. This was also illustrated by the drop of aggregate financing, to a 10-month low. Although aggregate financing typically falls sharply in July, the drop to CNY 719 bn was below market expectations.
More support likely
Although China faces a number of downside risks (see our China Watch published last week), we are still of the view that the authorities have many tools at their disposal to manage risks to growth and financial stability. The recent CNY moves are just another form of policy easing, but we expect the PBoC to continue with other easing steps as well to keep growth close to its 7% target and prevent a hard landing. We have currently penciled in one more 25 bp policy rate cut and 100 bps in RRR cuts, next to ongoing fiscal stimulus such as the recent launch of an infrastructure investment programme to be financed by state-policy banks. Should data continue to disappoint we anticipate even more easing to come.
In our view, the changes in China’s exchange rate regime are a first step towards restoring external competitiveness and towards introducing a more market based exchange rate regime. We do not think that the devaluation of the yuan will now trigger a currency war given that it is not too aggressive, while other countries also recognise that China’s economy faces challenges. Official reactions from other countries are in line with this view, as they are (relatively) benign so far.