Chief Investment Strategist
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By setting a much weaker than expected yuan “fixing” today, China’s central bank may be speeding up currency depreciation.
Thus, the driver of the August global financial market swoon is back. While Chinese local A-shares rose today, most global financial markets are weakening significantly as they assess the risk (and other factors).
Peoples Bank of China (PBOC) intentions remain unclear. For example, if the cost of intervention is impacting its decisions, it can only be estimated with lagged foreign reserves data.
The impact may be less of a shock the second time around, particularly as forward markets now price significant depreciation in 2016 already (as much as an additional -6%). By comparison, markets were unprepared last August after a decade of CNY appreciation. We would expect global asset markets to react negatively until the size of the CNY depreciation is somewhat more clear. This was also the case last August/September.
It would take a very large depreciation in China and a series of competitive devaluations in other currencies (where external currency debt burdens are high) to threaten global recovery. Global macro policies would also adjust around this view to drive offsetting stimulus. However, global investors should see China's currency as a market driver this year just as oil was in 2015.
Implications of Faster RMB Depreciation
Less than one week into 2016, the world has been greeted with China’s equity slump, Saudi-Iran conflict and a possible nuclear test by North Korea. As discussed in our Monday bulletin (“The Big Long,” US-Dollar Cycles and their Painful Extremes), most importantly, the fundamental driver of the August 2015 market swoon is back – China’s currency depreciation. While this may be less of a shock the second time around, particularly as forward markets already price in meaningful depreciation this year, we should expect global asset markets to react negatively until the size of the CNY depreciation is somewhat clearer.
Global investors should see China's currency as a market driver this year just as oil was in 2015. For the moment, in the event of accelerated further depreciation, we would expect a cross-market selloff that patterns the August swoon (see figure 1).
After persistent depreciation already seen in Nov-Dec last year, the PBOC appear to have accelerated the pace of depreciation in the New Year. It remains unclear what the PBOC’s intentions are, but recent developments raise significant questions about the gradualist approach of China’s FX policy.
The PBOC’s recent actions are confusing. Late in December, it suspended cross-border Chinese yuan business of several foreign banks, presumably to narrow channels that enable shorting . When the market continued to weaken the CNY on Jan 4th, the PBOC set the reference rate stronger on Jan 5th and managed to stabilize markets somewhat. Then on Jan 6th, the PBOC surprised markets and set the reference rate much weaker than the previous day’s close, effectively reversing the stabilization measures of the previous day.
Immediately after the reference rate was announced on Jan 6, the 12-month forward rate leapt over 6.90, weaker than the 2008 crisis peg level of 6.83 (see figure 2).
Chinese exporters clearly may benefit from this, as weaker RMB helps to widen their profit margins. But the impact on overall exports is likely muted because other competitor currencies have also weakened. But capital outflows could intensify as markets continue to expect more depreciation. If this process drags on longer, it would continue to erode FX reserves, which had already fallen by $555bn from Jul 2014 to $3.44tn in Nov 2015. Markets would be closely watching FX reserves data to gauge PBOC’s intentions.
Similar to last August, concerns over China exporting deflation would likely dominate markets in coming days, likely with influence over other policymakers. Several Fed speakers have recently noted the risks that China continues to pose to the outlook. The IMF’s chief economist warned China not to “spook” markets. These comments all came before today’s surprise fixing. Altogether, China’s recent currency moves likely would push G3 central banks marginally towards further accommodation, and away from tightening.
As discussed in our Outlook 2016 report, for suitable investors, we recommend exploiting gaps in cross-market volatility to hedge risk. High levels of expected volatility priced in one global asset class can’t be expected to be ignored in others.
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