How Low Will The Yuan Go? Deutsche Bank Answers

On Friday, the PBoC said it would seek to keep the yuan’s exchange rate “basically stable” at reasonable and equilibrium levels and work to further promote RMB internationalization.

As we noted earlier today, the more China moves to “liberalize” exchange rates and financial markets, the worse things will be for global risk assets. After all, when something that has been perpetually manipulated is suddenly subjected to a semi-honest price discovery process, the “adjustment” is usually violent. China is a case in point.

Indeed, turmoil in the Far East has been blamed for what has been the worst week “in recent history” (to quote RBS) for stocks and credit.

So what are the implications of more “liberalization” from Chinese authorities? What can we expect now that Beijing seems determined to not only participate in, but in fact win the global currency wars? What does it mean for the yuan to be kept “basically stable” in the context of China’s new trade-weighted RMB index?

Deutsche Bank has endeavored to answer some of those burning questions.

First, the yuan will need to “adjust” to the tune of 15% in the event the dollar rallies 5% against global currencies if the trade-weighted RMB is to remain stable. Note that it would need to fall a whopping 45% against the dollar in the event USD surges 15% against world currencies. Also note that this just assumes the RMB is kept stable (i.e. it doesn't account for a proactive move to weaken the currency further which is precisely what we've seen this week):

Put simply, the more global currencies weaken against the USD, so will the yuan. The easiest point of reference is the new CNY trade- weighted index published by the authorities last year. Taking the hypothetical case of a uniform drop of 5% in all world currencies against the dollar, this implies USD/CNY has to rise by around 15% to keep the yuan stable at current levels (chart 1). This of course implies that the currency is indeed kept stable rather than actively weakened, with the markets likely to closely watch whether we breach the key 100 level in coming weeks (chart 2).

 

Intuitively, if China moves to avoid trade-weighted RMB appreciation in the face of broad USD strength, the trade-weighted dollar will rise even more.

Put simply, if China allows USD/CNY to appreciate in line with dollar strength against other currencies, the broad trade-weighted dollar will appreciate by even more. Taking the September 2014 – April 2015 euro weakening period as a template, the broad dollar would have appreciated by 3% more had the Chinese authorities moved USD/CNY higher to offset weakness in EUR/CNY.

And that of course means the Fed will need to think carefully about further rate hikes if the FOMC wants to avoid crushing US corporate competitiveness in world markets: 

A stronger dollar, all else constant, means a slower Fed hiking cycle.

Now that China is all-in on the global currency wars, it will no longer serve as kind of pressure valve for global disinflationary pressure which means - you guessed it - more competitive easing from the likes of Mario Draghi and Haruhiko Kuroda in a desperate attempt to boost inflation:

Holding everything else constant, a higher USD/RMB (even if it just involves a stable trade- weighted currency) has negative growth and inflation repercussions for the rest of the world because currency moves are a zero-sum game. China has served as a major importer of global disinflationary pressure over the last few years and this is unlikely to continue. We note the market is therefore rightly pricing renewed odds of easing from both the ECB (and likely the BoJ), though it is important to highlight that even if this materializes it will likely be less effective than before: China will push back against competitive currency devaluations. Absent a major round of domestic Chinese easing (similar to the Japanese or European QE programs), the bigger the scale of intended depreciation on the RMB the more negative the impact on the rest of the world will be.

What's the takeaway, you ask? Well, the same as it's been since the August 11 deval. Namely, the market is struggling to understand whether China has a plan. That is, will the PBoC finally relinquish control and let the yuan find its way to a level that relieves the built-up pressure and thus stops capital outflows? Or will Beijing continue to pursue a devaluation on its own terms, thus setting the stage for more capital flight and a widening spread between the onshore and offshore spots? Nobody knows - and that is the real problem.

Bringing it all together, there are two potential long-term equilibria to China’s new currency policy: the exchange rate will either have to reach a new market- determined level that allows capital outflows to stop, or a series of restrictions on capital that prevent outflows from materializing in full force have to be put in place. From this perspective, the recent extreme widening between the onshore and offshore yuan rates (the CNY-CNH basis) give mixed signals. On the one hand it signals increased tolerance for currency weakness led by market forces. On the other hand, it is also indicative of the rising impact of capital controls (or “macroprudential” measures) because the greater the restrictions between the two markets, the smaller the ability to arbitrage the two rates and generate convergence.

 

Until the market acquires greater confidence on the intended scale of currency depreciation as well as the equilibrium level of capital outflows (and effectiveness of capital controls) concerns around China’s currency policy are unlikely to subside any time soon.

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