EM FX Weekly – Change in China’s FX regime

by: Roy Teo , Arjen van Dijkhuizen

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  • Change in China’s FX regime leading to a lower yuan…
  • …to support the economy and to facilitate the take-up in the SDR basket
  • …but the pace of depreciation will not be aggressive
  • Our new year-end forecasts for USD/CNY: 6.55 (2015) and 6.75 (2016) respectively

 

Change in China’s FX regime…

This week’s big move was the change in FX regime by the People’s Bank of China (PBoC). The USD/CNY fixing was adjusted by a cumulative 4.7% from 11-13 August. These adjustments were in line with the Tuesday statement, indicating that the fixing of the reference rate would be based more on actual market movements. On Thursday, the PBoC calmed financial markets by signaling support for the yuan. So far this week the yuan has weakened by around 3%

…to support the economy…

We think that this is a logical step from a Chinese perspective, as a weaker currency is needed to support the economy. A weaker yuan will help China to restore export competiveness, given the lacklustre export performance and also result in some upward pressure in inflation. The strong yuan has resulted in margin compression and companies’ profits. This could have negative implications on employment and wage growth. Weak wage growth will be headwinds to the State Council’s objective of shifting the economy towards a consumption model. For more details, please refer to our China Watch – A closer look at China’s currency moves, published on 13 August.

…and to facilitate the take-up in the SDR basket…

In addition, a more market based daily reference rate mechanism will help China to get the yuan included in the IMF SDR basket. The IMF recently indicated that the decision to include the yuan in the SDR basket may well be postponed to next year. Ahead of this decision, it is likely that Chinese authorities will further accelerate financial liberalisation. We still expect the yuan trading band to be widened from +/-2% to +/-3% later this year as China seeks a more flexible exchange rate regime. The trading band is likely to be widened only when volatility in the yuan comes down and the gap between the onshore trading spot rate and the yuan reference rate narrows.

…but pace of depreciation will not be aggressive

Meanwhile, the PBoC also faces some constraints with regard to a weakening of the currency. A sharp yuan depreciation in the yuan may spark currency wars and exacerbate capital outflows that China is seeking to contain. A much weaker yuan will also raise the debt repayment burden of entities with high US dollar –denominated debts. A sharp depreciation in the yuan may also result in less confidence for central banks to accumulate the yuan in their foreign currency reserves, which would run counter to China’s strategic goal to promote the global use of the currency.

In addition, businesses’ demand to use the yuan as a trade settlement currency may also decline. This could have negative consequences on IMF’s assessment on how widely used and traded the yuan is ahead of SDR basket decision later this year. Furthermore, the authorities have abundant capacity to stimulate the economy via fiscal and/or monetary easing. Hence a sharp depreciation in the currency to stimulate exports and inflate the economy is likely to be the last tool used. Last but not least, China still has sizeable external surpluses and huge FX reserves, enabling it to prevent disorderly yuan depreciation and/or speculation that the weakness in the yuan is a one way bet. Indeed there were market talks that the central bank intervened in the onshore yuan market on 12 August to calm the bearish sentiment in the currency.

A positive step towards more market based reference rate

In our view, the recent adjustment on the yuan reference rate is a positive step. The People’s Bank of China (PBoC) stated that an improvement in the central parity quotation will help reduce distortion and move the reference rate closer towards the equilibrium market rate. Nevertheless it will take some time for market makers to adjust quotation and trading practices to find the equilibrium price in the yuan. There has been encouraging signs that this is materializing. Before the new yuan reference rate pricing mechanism was implemented on 11 August, the onshore yuan spot rate was trading consistently around 1.5% discount to the reference rate. On 13 August, the onshore yuan spot rate was trading close to par to the reference rate, at the time of writing.

Our new year-end forecasts for USD/CNY: 6.55 (2015) and 6.75 (2016) respectively

As elaborated above, there are arguments for a weaker yuan, though it is not expected that the recent pace of depreciation will continue. As such we expect the onshore yuan (CNY) to decline to 6.50 and 6.55 in the third and last quarter of this year respectively. This would imply a 6% depreciation this year. Looking ahead we expect the CNY to depreciate by a smaller magnitude of 3% to 6.75 in 2016.

CNH discount to the CNY expected to narrow

As the offshore yuan (CNH) is more exposed to global market forces, the CNH is more volatile and tends to trade at a discount during periods of risk aversion arising from external or domestic events. During the peak of the European debt crisis in 2011, the CNH discount to the CNY widened to more than 1200 pips. However as global sentiment improved and liquidity in the CNH deepens, the average daily variation between the CNH and CNY narrowed to around 10 pips since 2012 as arbitrage opportunities take place. Hence, although a clear discount in the CNH is likely to persist in the coming weeks, we expect the CNH to trade close to the CNY later this year. As financial markets have not fully priced in that the Fed will raise the Fed funds target rate by 25bp in September, in our view, we expect the CNH to trade at a discount to the CNY well into September. Our 2015 Q3 USD/CNH target is 6.55. This is higher than what the CNH forwards market are currently pricing in. Looking ahead, we expect the USD/CNH to trade closer to our USD/CNY forecasts in subsequent quarters.

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