The race to call the expected depreciation in the Chinese yuan is now on in earnest.
In a note released last Friday, Barclays analysts have taken a sword to their year-end target for the yuan, upping their forecast for USD/CNY from 6.35 to 6.80.
Barclays believe the yuan is currently overvalued by 18% based on their model which evaluates purchasing power parity, its historic valuation and changes in fundamentals such as relative labour productivity, terms of trade, relative government size as a fraction of GDP and the net foreign assets position.
While Barclays believes its model exaggerates the overvaluation, it still feels it’s reasonable to expect the currency to weaken by a further 7% before year-end, with risks tilted to the upside.
“Although a modest overvaluation, as per our analysis, does not imply that previous USDCNY levels were necessarily unsustainable, we do think it would have been reasonable to expect a 10% depreciation relative to these levels before this week’s announcement by the PBoC. So far USDCNY has risen by 3%, hence, a further 7% move would put USD/CNY spot at around 6.80. Given this, we have revised our year-end 2015 forecast for USDCNY to 6.80 from 6.35, and expect relative stability thereafter, albeit still with upside risks. This view assumes that the Fed ignores the global turmoil and raises rates in September, in line with the expectation of our US economists.”
While a rapid 10% depreciation against the US dollar will positively impact at the margin for Chinese GDP and consumer price inflation – the bank believes it would add 0.2ppts to GDP and 0.5ppts to CPI in 2016 – it has the potential to create negative headwinds for growth and inflation elsewhere, particularly in Japan and the euro area.
Barclays forecast that a rapid 10% yuan depreciation would shave 0.25ppts and 0.19ppts off Japanese GDP and CPI in 2016. For the euro area, the impacts would be even greater in their opinion, slicing 0.31ppts from GDP and 0.3ppts from CPI.
Given Japan and the euro area are both emerging from a protracted period of economic weakness, should Barclays be correct on their call, it implies that both Japan and the eurozone could look to stymie these negative headwinds by introducing additional monetary policy easing in an attempt to keep their respective currencies weak.
While neither Japan nor the eurozone have suggested that is a possibility at present, it will be interesting to see whether that remains the case should the yuan continue to weaken.
It’s easy to see why markets are uneasy about a potential escalation in the global “currency war”.