The implications of China’s currency adjustment

A string of macro events in recent days have sent financial markets into a tailspin; starting with the US Fed’s less than dovish forward guidance following the 25bp rate cut. That said, markets have become particularly jittery about the escalating trade tensions and the US designating China as a ‘currency manipulator’ soon after the Renminbi (both onshore USD/CNY and offshore USD/CNH) broke the psychologically important 7-level.

The latter two have broader implications on the global economic and market outlook amid a backdrop of weakening US macro data. If the Trump administration proceeds with the 10% tariffs on the remaining USD300 billion worth of Chinese exports to the US, China may also expand its retaliatory tariffs to all US exports to China. Reduced trade activities will have an adverse impact on both economies.

On the currency front, it is difficult to justify labelling China as a currency manipulator based on the criteria outlined by the US Treasury. In fact, the statement from the US Treasury chose not to mention the three criteria under the Trade Enforcement Act of 2015 by which it can label a country as a currency manipulator1:

  • a) The country’s bilateral trade balance with the US is > USD20 billion;
  • b) the current account surplus is more than 2% of GDP; and
  • c) the country has intervened to purchase the US dollar and sell its local currency equivalent to more than 2% of its GDP over the past 12 months.

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Of the three criteria, China only meets (a), NOT (b) and (c). China’s current account balance only averaged 1.0% of GDP over the past four quarters. The country’s net foreign exchange intervention, per US Treasury estimates, was -0.2% of GDP in the 12 months up to April 2019. Furthermore, Eastspring Singapore’s Multi Asset Solutions Team believes that China’s real effective exchange rate is currently above its 10-year average (see Fig. 1), implying the currency is ‘overvalued’, rather than ‘undervalued’, as the US Treasury claims.

Fig. 1: China’s real effective exchange rate (REER) continues to run above its 10-year average2

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Reinforcing their view were the International Monetary Fund (IMF) and the People’s Bank of China (PBOC). In its latest country report, the IMF concluded that “… the Renminbi remains broadly in line with fundamentals even as the external position in 2017 was moderately stronger than implied by fundamentals…”3.

Additionally, the governor of PBOC commented on 5 August 2019 (Monday) that “the CNY exchange rate is now at an appropriate level, from both China’s economic fundamentals and market supply-demand point of views”. The central bank further explained that the depreciation of the Renminbi beyond 7 was mainly caused by unilateralism and trade protectionism.

However, given US’ stance that China is using currency devaluation to gain unfair trade advantage, the Multi Asset Solutions Team believes the Chinese authorities will be under pressure to engineer a more modest Renminbi depreciation in the near term. And, if the US authorities remain unhappy with the currency moves, a further escalation in the trade war, such as raising tariffs from 10% to 25% on USD 300 billion worth of goods, cannot be ruled out. Such an outcome will strengthen the case for further Fed rate cuts in the next few meetings, making a September cut a high possibility.

Eastspring Singapore’s Fixed Income Team is also of the view that central bank will keep the Renminbi weakness in check and that it is unlikely that China will undertake indiscriminate depreciation of the currency which could a) raise the ire of the G7/20 communiques denouncing competitive devaluation, b) jeopardise ongoing efforts to encourage domestic capital market inflows, and c) trigger capital outflow pressures.

Nonetheless, the Renminbi breaking the 7-level is an important development for the global foreign exchange market. The Chinese currency exchange rate has been regarded as a stabiliser, especially for Emerging Market (EM) currencies. Thus far, the Multi Asset Solutions Team believes that the PBOC has been keen to keep the Renminbi relatively stable. If the central bank changes its stance and the Renminbi experiences greater volatility, it may have repercussions on other Asian currencies, particularly those of small open economies, such as the Singapore dollar, the Korean won and the new Taiwan dollar.

Ultimately, Chinese authorities have made significant strides to open their domestic financial markets. China would not want to lose market credibility as its bonds are being included in the Bloomberg Barclays Global Aggregate Index4.

Recent policy announcements have also been towards greater openness, including a more recent measure to remove shareholding limits on foreign ownership of securities, insurance and fund management firms by 2020. If the trade war poses further downside risks to China’s growth, the Multi Asset Solutions Team thinks that Chinese authorities would prefer to ease monetary conditions and loosen fiscal policy further to ensure that growth remains steady.

Investment implications

According to the Multi Asset Solutions Team, uncertainty about the trade war will continue to cloud market action in the near term and lead to further risk-off moves. Long duration and foreign exchange hedging trades will continue to work well, whilst emerging market equities are likely to remain under pressure.

In the medium term, gradual RMB depreciation is inevitable as China’s current account surplus narrows. That said, USD/CNY (onshore Renminbi) has more room to go on the upside. The challenge now is for the authorities to mitigate capital outflows.

The Multi Asset Solutions Team is currently neutral on equities (with a slight preference towards US equities) and overweight credit through US and Asian high yield bonds, together with Indonesia local bonds which are most likely to be impacted by the risk-off move but a number of portfolio hedges including long US Treasuries, short EUR/JPY, will perform well in this environment.

On Chinese credits, the Fixed Income Team is of the view that even within the high yield property sector, which has relatively larger foreign currency debt exposures, the impact of currency depreciation should remain manageable at current juncture. This is partly premised that the Renminbi depreciation pressures should be capped by the PBOC to prevent disruptive capital outflow pressures.

Further, the size of the companies’ earnings and profit margin should help cushion the impact of higher debt servicing costs. In the near term, however, investor sentiment is likely to be soft, and credit spreads could still widen as in the past episodes of Renminbi weakness. The Fixed Income Team believes that a bottom-up selection remains key as the smaller companies which have higher non- Renminbi debt exposures could be hit harder if Renminbi weakness is sustained.