Overnight the PBOC made a surprise announcement and today the market reacted badly. We offer our thoughts on this development in FAQ form.
Overnight, the PBOC made this surprise announcement: “Effective from 11 August 2015, the quotes of central parity that market makers report to the CFETS daily before the market opens should refer to the closing rate of the inter-bank foreign exchange market on the previous day, in conjunction with demand and supply condition in the foreign exchange market and exchange rate movement of the major currencies.”
Markets have reacted badly to this surprise. We offer our thoughts below in a FAQ format. In general, we are a bit more sanguine than the markets, and do not think China is embarking on a campaign to weaken the yuan. We do think it could have been handled better, perhaps via a slow and steady move rather than a one-off. We do not look for excessive CNY weakness ahead, and believe the trajectory for EM and global markets will be largely determined more by Fed monetary policy than by Chinese FX policy.
Is this another shot in the “Currency Wars?”
No. We do not think this is an attempt by China to devalue its way to growth. A 2% move is negligible, in light of how much CNY has appreciated in REER terms. Not to mention that most EM currencies have already weakened to nearly match the CNY move today. Instead, we take China policymakers at their word that this is meant to introduce greater market forces into determining the exchange rate.
Are Chinese policymakers panicking?
No. The fall in FX reserves has made for good stories, but it’s far from being a concern. Reserves are down $342 bln since their mid-2014 peak near $4 trln (-8.5% through July). China is still running a healthy current account surplus, but we think the capital account is key going forward.
What does this mean for the Chinese economy?
At this point, not too much. Estimates put the value-added component of China’s exports between 20-33%, so the competitiveness benefits of a weaker currency are negligible. We think other policy measures (monetary and fiscal stimulus) are likely, and would have a much greater potential impact on real economic activity than today’s devaluation.
What does this mean for the yuan exchange rate?
We do not think China will devalue again per se. By giving the market a bigger role, policymakers can simply chalk up any further currency weakness to market forces. The use of the previous day’s close and current FX developments does suggest a greater market role. However it is still a black box, when all is said and done. Eventually, we think that policymakers would like to eliminate the daily fix altogether, and to unify and onshore and offshore exchange rates.
We believe that continued CNY weakness (-2% YTD) is likely, but the pace is likely to be very restrained. If and when Fed liftoff is seen, EM will likely come under greater pressure. We think CNY will continue to outperform within EM. TWD (-1.2% YTD), INR (-1.8% YTD), and PHP (-2.7% YTD) show that there continues to be positive divergences seen within EM. Going forward, we think CNY will most likely trade closer to these outperformers rather than to the underperformers like BRL (-24% YTD), COP (-19% YTD), and TRY (-16% YTD).
What does this mean for global markets?
Markets are taking this as negative for EM and “risk” in general. Equity markets are down, while bond markets are up. Commodities and EM currencies are weaker. While we remain negative on EM due to several factors, we do not think this devaluation will have a lasting impact. We note that before the devaluation, EM currencies were already sharply weaker YTD. As such, there is no fundamental reason why the Brazilian real (-24% YTD) or Turkish lira (-16% YTD) should have to weaken further in response to a -2% move in the yuan. Our negative EM call hinges on Fed tightening and low commodity prices, not on the likely path of CNY.
What does this mean for the internationalization of the yuan?
We think this is another step in that process. Indeed, we believe the IMF will look favorably on this attempt to allow for greater market forces in determining the exchange rate. Inclusion into the SDR basket is not a done deal, but cautious official comments suggest that it will happen once the IMF’s concerns are met. China has already adopted stricter norms for transparency on its debt and foreign reserves data, and it will continue to along this path in the coming months ahead of the September 2016 SDR decision by the IMF.