No Near-Term Currency Regime Change in China

 (from my colleagues Dr. Win Thin and Ilan Solot)

Spot USD/CNY closed above the fix today for the first time since September 2012. We saw a prolonged period of this in Q2 and Q3 2012, right after the last band widening. But to keep things in perspective, spot is still closer to the center of the +/- 1 percentage point trading band around the fix rate than it is to the upper band. Further yuan weakening appears likely, but not on a scale large enough to spook the markets.

Other factors are at work in China currently, making it even harder to read the true intentions of Chinese policymakers. It is interesting to note that China started draining liquidity again over the last week, for the first time since mid-2013. Yesterday, for example, the PBOC conducted a RMB 100 bln operation. This draining started around the time when the yuan began to weaken. So one possible interpretation for these events would be that the PBOC could be slightly shifting its support from one sector of the economy (bank lending driven construction and real estate, for example) to another (exporters). Recall that inflation in China is well contained, with CPI at 2.5% y/y and PPI at -1.6% y/y in January, so pass-through from a weaker currency is not an issue.

We do note that China’s Real Effective Exchange Rate (REER), as measured by both the IMF and the BIS, is at all-time highs. Simply put, Chinese exporters have experienced a secular decline in competitiveness, through a combination of inflation differentials and relative exchange rate movements in its major trading partners. We believe that officials would like to contain further REER appreciation by moving the nominal exchange rate weaker.

All of these developments come against a backdrop of slowing growth. While we do not expect a hard landing in China, we do believe firms are struggling with the rebalancing towards slower, domestic-led growth. Despite the stronger than expected January trade data from China, we remain skeptical and believe that a truer picture is given by Hong Kong and others reporting weak trade data in EM.

Reserve accumulation has continued, despite stable to falling external surpluses. In Q4, the trade surplus was $90.5 bln and the current account surplus was $49.8 bln, while reserves rose $157.3 bln. Similarly, the Q3 trade surplus was $61.1 bln and the current account surplus was $40.4 bln, while reserves rose $166 bln. One potential goal of recent CNY/CNH weakness (and greater two-way risk) is to perhaps discourage hot money/carry trade inflows into China that see currency appreciation as a one-way bet. In addition, highly leverage structured product positions in CNH would exacerbate the moves.