PBOC and the Yuan: Near-term panic over but still likely end of an era

Last week’s PBOC update to their FX policy – substantially raising the CNY daily fix three times and, more importantly, apparently giving market forces a larger (if slightly opaque) role – led to substantial global FX volatility. With the benefit of a couple of days distance the bottom lines seem to be: (a) PBOC will likely intervene to prevent a near-term repeat of this weeks’ volatility, but markets will likely remain nervous and could well test the PBOC’s hand; (b) Markets underweighted the Chinese authorities’ awareness of the risks of currency wars; (c) the era of yuan TWI uptrend is likely coming to a close, with risks skewed to depreciation; (d) Chinese developments have more powerful impact on global inflation given the rise in trade penetration, with considerable cross-country heteregeneity; (e) the yuan will likely be less of a regional anchor for Asian currencies than in recent years.

The FX impacts of Chinese developments will be felt via three main channels: (i) weaker Chinese demand for a country’s exports (the trade channel) where other Asian currencies (KRW, PHP, MYR, THB) and commodity exporters (ZAR, AUD, CLP, BRL, PEN, NZD) look most exposed but European FX significantly less so; (ii) deflationary effects from China’s negative producer price inflation, especially with further CNY weakness, and downward pressure on commodity prices – where AxJ countries already suffering from producer price deflation and low CPI inflation (KRW, SGD, THB) look most exposed although there are also large exposures in other countries including JPY, USD, AUD and NZD in G10 but European FX exposures are again generally smaller; (iii) risk aversion effects from uncertainty about the Chinese situation – where EUR (as a funding currency) and safe havens (JPY,CHF) will be supported but risk-on currencies will suffer.

(a) PBOC will likely intervene to prevent a near-term repeat of this weeks’ volatility, but markets will likely remain nervous

The PBOC prevented this week’s initial volatility morphing into a rout by ramping up their verbal and actual intervention: the market stabilised on Thursday and Friday. The verbal intervention: (i) put a positive spin on recent data; (ii) stressed that there’s no basis for a sustained depreciation – with there being no need for CNY to fall to boost exports; (iii) committed to intervene when the market becomes excessively volatile or swayed by herd behaviour; and (iv) announced that CNY’s adjustment after the fixing method change is “basically already completed”. My take is that (iii) and (iv) were the most important.

The PBOC’s apparent surprise at the scale of market moves on Tuesday and Wednesday betrays some naivety, given that essentially out of the blue they raised the fix by the most in two decades. That was bound to cause a collective scratching of heads at the least if not worries about PBOC entering the currency war (it followed last weekend’s report of exports falling 8.1% yoy and the IMF saying that CNY was no longer undervalued) or indeed “they don’t know what they’re doing” concerns.

In PBOC’s defence, while their recent interventions preventing CNY falls should have told the PBOC that there were downward pressures their extent will have been difficult to judge. And the IMF’s 26 May argument that the yuan is no longer undervalued appears suspect (as do trade surplus motivated US Treasury arguments that it remains undervalued).

While the spot FX situation has stabilised, forwards continue to price in moderate further yuan falls.  Moreover, markets will likely remain nervous about the PBOC’s motivation and its ability to control the situation. Here, implied vols and risk reversals remain elevated, albeit down from their peaks immediately after the PBOC’s announcement.

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(b) Markets underweighted the Chinese authorities’ awareness of the risks of currency wars.

Market concerns that the PBOC was escalating currency wars was to some extent understandable given the opaque communication. But markets seem to have forgotten that in March premier Li Kequiang signalled that the Chinese authorities are aware of the dangers: “We don’t want to see further devaluation of the Chinese currency, because we can’t rely on devaluation of our own currency to boost exports. We don’t want to see a scenario in which major economies trip over each other to devalue their currencies. That will lead to a currency war, and if China feels compelled to devalue the RMB in this process, we don’t think that this will be something good for the international financial system”. PBOC have also signalled that they are cognisant of the dangers of capital flight should expectations of sharp renmimbi falls take hold: they scotched reports that they were looking for a 10% fall. Moreover, China watchers should be aware that Chinese reforms tends to proceed stepwise relatively slowly, with the authorities assessing the impact of each step before proceeding further. Deng Xiaoping described this as “crossing the river by feeling the stones” – although perhaps now the stones are further apart than the market previously thought.

(c) Era of yuan uptrend coming to a close, risks skewed to depreciation

Given (b) I’m not expecting PBOC to aim for sharp further CNY depreciation – slow and steady is the most likely scenario. But my bias is that the PBOC are being a bit optimistic about the economy and that the risks are skewed to further CNY falls being required to support the longer-term rebalancing.

Notably two of Li Kequiang’s three favourite demand indicators paint a substantially more negative picture than the suspiciously-smooth official GDP data. The exception is credit growth – indeed bank lending jumped to 15.5% yoy in July, the strongest since November 2011. But with debt at around 260% of GDP (up from 120% pre-GFC) the efficacy of such lending can certainly be questioned e.g. it has not prevented the housing market stumbling. Last week’s industrial production, investment and retail sales data also all disappointed. And it’s hard to see producer price deflation coming to an end any time soon given debt disinflation dynamics and oil prices falls, although the former represent a positive terms of trade shock for China. Moreover, history suggests that rebalancing the economy away from investment and trade towards consumption is a tough gig.

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Indeed, some of China’s disinflationary problems seem to have been imported: the CNY real TWI has appreciated by 14% since May 2014 and by 58% since early 2005. That didn’t seem to have that much impact on Chinese exports until recently: Chinese export market share had continued rising until start-2015. But the more recent export decline may have raised concerns that a tipping point had been reached (combined with the sharp fall in the Shanghai stock market). So at the least the Chinese authorities seem more likely to be concerned about further yuan rises. And their focus may well be shifting away from USDCNY and towards the TWI.

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One little-discussed motivation for the timing of the PBOC’s actions was the forthcoming FOMC liftoff. The PBOC may have hypothesised that this would further support the dollar – based upon growing monetary policy divergence, although USD general weakening after the start of previous Fed rate increase cycles casts doubt on this (something that I intend covering in a future blog!) – and decided to get ahead of the curve in order to forestall further CNY TWI rises. The obvious analogy is to the SNB CHF peg abolition in advance of ECB QE (albeit SNB were trying to forestall CHF strength) and by this metric perhaps the PBOC didn’t do so badly last week.

But overall, the desire to clear a barrier for the yuan’s inclusion in the IMF’s SDR basket i.e. contribute to the Chinese strategic objective of obtaining reserve currency status was also an important motivation. Indeed, the IMF welcomed the PBOC’s move: “Greater exchange rate flexibility is important for China as it strives to give market forces a decisive role in the economy and is rapidly integrating into global financial markets“.  And its notable that the PBOC’s announcement met some of the points laid out in a recent IMF paper on SDR inclusion.

(d) Chinese developments have more powerful impact on global inflation.

The corollary of the continued rise in Chinese export market penetration, to over 12% of world exports in the year to start-2015 compared to 8-9% before the financial crisis, is that movements in Chinese (producer price) inflation and CNY exchange rates have more widespread and profound impacts on global inflation (with trade flows and commodity prices representing the other channels of transmission via which Chinese developments affect the global economy and FX markets).

The vertical axis of the Chart below provides an initial cross-country diagnostic on exposure to potential deflationary pressures from China by examining the variations in the share of a country’s imports coming from China. The main point is that for most G10 countries this is non-trivial and exceeds the proportion of their exports going to China (i.e. the trade channel, shown on the Chart’s horizontal axis). Within the G10 the most exposed countries seem to be JPY, USD, NZD and AUD, with European currencies appearing less exposed.  The US economy’s relatively closed nature suggests downplaying the relatively-high raw number, but markets nevertheless initially pushing back Fed rate hike expectations a little given the knife-edge nature the Fed’s September decision and underperforming US inflation.  The exposures of other EMs are generally higher, supporting concerns about currency wars spreading, particulary in the other Asian countries also suffering from producer price deflation and low CPI inflation (KRW, SGD, THB).

The horizontal axis illustrates the most exposed countries to a slowdown in Chinese demand (the trade channel) are the other Asian nations (KRW, PHP, MYR, THB) together with commodity exporters (ZAR, AUD, CLP, BRL, PEN, NZD).  The exposures of GBP, SEK, NOK and eastern European currencies being lowest (short-term benefits of being slow to get on the China bandwagon!). And interestingly those export links broadly coincide with the relative FX moves during the sharp movements on Tuesday and Wednesday (see 2nd chart below), which could well provide a useful template for the likely relative moves in the coming months. Indeed, these data tend to understate the effects of a Chinese slowdown or CNY depreciation on Asian exports since they do not account for the high competition in third countries (which TWI weight do, but are more cumbersome to dig out).

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The finding that EURUSD was one of the biggest gainers on Tuesday/Wednesday might seem surprising given its recent low inflation problem (and vulnerable breakevens), it has one of the highest import penetration values of the European currencies (around 12½% of EA imports come from China, versus under 7% for the UK) and is an open economy. Rather, the rise in EURUSD back above 1.11 seems to reflect higher risk aversion (falling global equity prices) engendered by the surprising PBOC news undermining the EUR shorts associated with the EUR’s post-QE role as a funding currency (see here and here).  A similar argument holds for the initial falls in USDJPY and USDCHF, where JPY’s and CHF’s safe haven characteristic outweighed lowflation concerns, Japan’s high exposure to potential Chinese deflationary pressures and both countries’ exports being exposed to weaker Chinese demand.

My companion post argues that the consequent rise in the EUR, last week’s disappointing EA GDP data and the continued fall in EA inflation breakevens alongside recent oil price declines increase the chances of the ECB sounding more dovish or jawboning the EUR at the 3 September press conference (although still short of being the central case).

(e) less of a regional anchor for Asian currencies.

The other sense in which the PBOC’s actions may well signal an end of an era is in providing a regional anchor for Asia currencies. The PBOC should in retrospect receive some plaudits for maintaining its USDCNY peg during the global financial crisis which likely prevented the crisis taking on another dimension.

The unfortunate corollary, however, was that other Asian countries also essentially imported US monetary policy and tended to accumulate USD-denominated external debt. So the now find themselves in the difficult position of being squeezed both by the forthcoming Fed rate liftoff (although this could at the margin be delayed by the recent China-induced volatilty) and an increase in the local currency value of their USD-denominated debt if they don’t fight the likely fall in their currencies, versus hurting growth if they do fight the FX moves by raising rates.

But given the issues facing the Chinese economy the PBOC will less inclined to act as a source of regional stabiility within Asia.  The PBOC may well be asking why China should keep acting to absorb deflationary pressures from Japan and the Eurozone.  As discussed above, PBOC focus could well switch to focussing more on CNY TWI (avoiding further rises) rather than USDCNY.  In other word, while the PBOC has backtracked in the near term things seem unlikely to go back to how they were – likely to the detriment of AXJ currencies exposed to deflationary pressure and weaker demand from China on top of their exposure to US rate rises and USD appreciation.

Overall, there are clearly numerous meaty issues to think through here e.g. how the PBOC proceeds over longer windows and whether it will be ablle to avoid further market volatility (is a step jump better than slow and steady?).

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