Chinese Yuan (CNY) - October 2016

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The UK’s shock Brexit vote in June and a relatively weak US labour report in August has now ensured we’re unlikely to see multiple interest rate increases in the US in 2016. We now expect just one hike from the Federal Reserve in December followed by further increases on a quarterly basis thereafter. Meanwhile, almost every other G10 central bank remains overwhelmingly in easing mode.

In the UK, the Bank of England cut interest rates for the first time in nine years in August, with the European Central Bank looking likely to expand its quantitative easing measures later in 2016. Further, the Bank of Japan announced a modest expansion of its monetary stimulus program, while the Japanese Government will significantly expand stimulus spending.

We think that the backdrop of extraordinarily stimulative policy from the main central banks, with the notable exception of the Federal Reserve, and a clear shift towards more accommodative policies in the laggard economies (e.g. Japan) is generally positive for risk assets and emerging market currencies in particular.

After many years of being pegged against the US Dollar, the People’s Bank of China (PBoC) last year moved to keeping the Yuan stable against a basket of currencies whose weights are set in rough relationship to their weight in Chinese trade. In addition to keeping track of this basket over the medium-term, the PBoC intervenes to prevent sharp daily moves (over 2%) against the US Dollar.

Following the removal of the soft peg and the devaluation of the Chinese Yuan in August 2015 the currency of the world’s second largest economy has depreciated sharply in value against the US Dollar. The Yuan has now lost over 8% of its value since the beginning of 2015, falling to its weakest levels in nearly six years in July (Figure 1) and becoming the worst performing major currency in Asia this year.

Figure 1: USD/CNY (2011 – 2016)

Source: Thomson Reuters Datastream Date: 30/09/2016

The recent sharp depreciation in the Yuan has followed a string of weaker than expected economic data which has added to growing concerns about the health of the Chinese economy. Economic growth has slowed down in the past few years, and the country has been overtaken by India as the fastest growing major economy in the world. GDP expanded by a better-than-expected 6.7% in the second quarter of the year (Figure 2), a level that the IMF expects to be essentially repeated next year.

Figure 2: China Annual GDP Growth (2006 – 2016)

Source: Thomson Reuters Datastream Date: 30/09/2016

Industrial production and retail sales are still growing strongly, particularly the latter. However, the rate of growth has delcined singificnalty in the past few years to more sustainable levels. The manufacturing sector has also held up relatively well so far this year, and the PMI’s s from both Markit and Caixin have increased in 2016 back above the level of 50 that denotes expansion (Figure 3).

Figure 3: China Manufacturing PMI’s (2014 – 2016)

Source: Thomson Reuters Datastream Date: 30/09/2016

Exports in China have continued to fall in US Dollar terms, remaining in negative territory year-on-year in every month but two for the past year-and-a-half. However, the Yuan has weakened significantly against its trade-weighted basket of currencies so far in 2016 and, in the more relevant CNY terms, exports have actually begun increasing again, rising by 3.9% in the year to August (Figure 4).

Figure 4: China Exports in USD & CNY (2015 - 2016)

Source: Thomson Reuters Datastream Date: 30/09/2016

Despite the recent stream of poor economic data, the People’s Bank of China has opted not to ease its monetary policy in the last few months, having cut its benchmark rate aggressively in 2015. The interest rate was last lowered by 25 basis points to 4.35% back in October last year, while the reserve ratio has been kept unaltered since March with policymakers no doubt wary of overstimulating the country’s housing market. The PBoC has instead used a range of unconventional methods, including injecting banks with short-term liquidity.

However, persistently weak inflation data in the country has led to increased speculation that rates could be lowered further in the coming months. Headline inflation in China plunged to 1.3% in August (Figure 5), its lowest level since May last year and comfortably below the central bank’s 3% medium term target. Producer prices have also now fallen in annual terms in every month for over 4 years having declined by 0.8% in August and providing further incentive for the PBoC to ease monetary policy before the end of the year.

Figure 5: China Inflation Rate (2010 – 2016)

Source: Thomson Reuters Datastream Date: 12/09/2016

China’s hoard of foreign exchange reserves, the largest in the world, has also continued to decline so far in 2016, albeit at a decelerating rate. Reserves slipped to their lowest level since 2011 in August, falling by $15.9 billion to $3.19 trillion, and have now declined by nearly a quarter in the past eighteen months although still remain vast (Figure 6).

Figure 6: China Foreign Exchange Reserves (US$ millions) (2000 – 2016)

Source: Thomson Reuters Datastream Date: 30/09/2016

The People’s Bank of China has remained active in the FX market this year, intervening on a regular basis in order to protect the currency and prevent an unwanted excessive sell-off in the Yuan. However, reserves tentatively appear to be stabilising, reflecting valuation effects from Dollar weakness and a slowing on capital outflows as Chinese authorities tighten controls.

We think that Chinese authorities will be opposed to allowing a continued sharp depreciation of the Yuan and expect the PBoC to continue to intervene in the FX market in order to support the Yuan against its major peers. One of China’s key long term goals is the internationalisation of the Yuan as a means of exchange and store of value, and a further decline in the currency would therefore shake currency and ultimately be self-defeating.

Further, a weaker CNY would run counter to the goal of rebalancing the Chinese economy, away from investment and towards domestic consumption. We therefore continue to expect the People’s Bank of China to stand by their implicit goal of keeping the Yuan stable against its trade-weighted basket of currencies.

Given the divergence in monetary policy stances between the Bank of Japan, European Central Bank and Federal Reserve we forecast only gradual losses for CNY against the US Dollar from current levels and a rather sharp appreciation of the Yuan against both the Yen and the Euro.

 

 

USD/CNY

EUR/CNY

GBP/CNY

E-2016

6.75

6.90

9.00

Q1-2017

6.76

6.70

8.90

Q2-2017

6.77

6.57

8.87

Q3-2017

6.78

6.50

8.80

E-2017

6.80

6.45

8.85

E-2018

6.85

6.50

8.90

 

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