How is China Faring?

(from my colleague Dr. Win Thin)

Despite the weaker economic data in China, the PBOC continues to guide USD/CNY lower. Earlier today, it was fixed at another cycle low of 6.2208. At this point, we do not think that China has embarked on another significant appreciation cycle for the yuan, as we saw back in 2005-2008 and 2010-2011. Our base case remains largely sideways trading, but with larger monthly and quarterly variations in the nominal exchange rate. With regards to GDP growth, we retain our view that it is likely to remain in the 7.5-8.0% range in both 2013 and 2014.

As always, it is important to keep in mind that the CNY rate is as much a political decision as it is an economic one. We believe that talk of yuan band-widening will continue to make the rounds, but that it will ultimately be done in a very limited and controlled manner. With appreciation pressures strong right now, we think a significant band-widening would lead to greater than desired appreciation of the currency. Given heightened growth concerns, we do not think an imminent move fits in with the usual PBOC modus operandi.

When the strict yuan peg ended in July 2005, the +/- 0.3% trading band was put in place for USD and +/- 1.5% for non-dollar foreign currencies. Then in September 2005, non-dollar trading bands were widened from +/- 1.5% to +/- 3% but the narrow USD band was maintained. The USD trading band was then widened from +/- 0.3% to +/- 0.5% back in May 2007. In April 2012, the USD band was widened from +/- 0.5% to +/- 1%, which is where it stands now. Looking at past patterns, we think it might be too aggressive to expect PBOC to move the USD band from +/- 1% to +/- 3% in one big move.

We think that China will continue to liberalize the exchange rate regime but the process will remain slow and steady. US Treasury declined to name China a currency manipulator recently, and we suspect the two countries are working together to find some sort of workable solution to the North Korean problem. As such, we expect less friction about the yuan exchange rate in the coming months.

Q1 GDP growth came in at a disappointing 7.7% y/y vs. 7.9% y/y in Q4 and the cycle trough of 7.4% y/y in Q3. We have long held that the recovery would be modest and, at times, spotty, given the fairly modest stimulus measures seen in 2012. We see growth gyrating around 8% for the time being, but acknowledge the risks are skewed towards reading in the 7.5-8.0% range rather than the 8.0-8.5% range. We remain confident that any sub-7.5% readings will trigger a stronger policy response in China. The political transition continues, and new leadership does not want to deal with heightened social tensions in their first year at the helm.

Yet despite this softness, the PBOC continues to let the yuan firm. So far in Q2, CNY has gained 0.7% vs. USD vs. 0.3% in Q1 and 0.9% in Q4. During times of economic slowdown and downside risks to growth, Chinese policy-makers typically keep the yuan trading sideways, as we saw during the 2008-2010 global financial crisis period and again during the H1 2012 euro zone debt crisis period. 

Furthermore, China’s real effective exchange rate (REER) has climbed even more, driven not only by the nominal currency gains but also by relatively higher inflation rates compared to its trading partners. Given the downside growth risks, we do not think China policymakers are prepared to accept much more in the way of currency appreciation, both real and nominal.

Lastly, we remain very concerned about the spread of the bird flu virus. While it is too early to contemplate the overall impact on the Chinese (and the Asian region as a whole), the downside risks come at a time of intensified global weakness. Simply put, China does not have much margin for error here.