CBA: Stop worrying about China's currency

There’s plenty to go around. Picture: Getty Images

Despite recent stability in Chinese renminbi, concerns over the outlook for the currency persist across financial markets.

The sudden devaluation of the currency in August last year, something many speculate was due to a sharp deceleration in economic growth, rattled financial markets at the time, causing widespread declines in risk assets across the globe.

It was even enough to see the US Federal Reserve hold off lifting interest rates for the first time since June 2006.

After the admission of the currency into the IMF’s special drawing rights (SDR) basket in late November, market concerns – already elevated – went up a notch. For weeks the renminbi weakened against the US dollar, leading to renewed market ructions at the start of 2016.

Tepid economic data, constant intervention from the China’s central bank along with signs of increased capital flight from the country only acted to fan investor concerns.

While financial markets have welcomed recent stability in the currency, pushing risk assets higher since mid-February, concerns, at least under the surface, persist.

From its current level of 6.5200 against the US dollar, many forecasters believe that the renminbi will weaken further in the year ahead. Figures of 6.7 to the dollar, or higher, are now commonplace. Some believe the decline, sparked by the potential for a banking crisis on the back of a huge lift in loan defaults, could be significantly worse.

Though some continue to price in an Armageddon-type scenario for the Chinese economy and the renminbi, not everyone shares those concerns.

To some, markets have misread the recent developments, suggesting that the recent weakness in the currency and sharp decline in FX reserves is not a sign that Chinese authorities are about to implement a massive, nerve-wrangling depreciation that will shake financial markets.

Richard Grace, CBA’s chief currency and rates strategist, is one who doesn’t share that view. In a research note released earlier today he outlines four reasons why, in his opinion, a significant weakening in the renminbi is unlikely to eventuate.

He suggests that concern over the People’s Bank of China’s (PBOC) decision to allow market forces a greater role in determining the renminbi’s value was not about a sharp slowdown in the Chinese economy but rather due to “operational reasons”.

“The August 2015 ‘one-off 1.9% devaluation’ was necessary for the CNY to be admitted into the SDR basket,” says Grace. “Prior to August 2015, the gap between the USD/CNY daily fix and the USD/CNY exchange rate averaged 1.5%.

“The IMF had made it clear that this gap had to be closed to illustrate operational control over the managed floating exchange rate.”

As for the recent decline in the Chinese FX reserves, Grace believes that it not simply a case of the PBOC defending the value of the renminbi through widespread liquidation of its reserves, suggesting that nearly half of the decline seen since June 2014 was due to valuation effects from a stronger US dollar alone.

“The large non-USD share of China’s foreign exchange reserves means that a rise in the USD will, by definition, generate a large valuation decline in almost half of China’s foreign exchange reserves,” says Grace. “When the USD rises, China’s reserves decline.”

“According to the calculations in China’s quarterly balance of payments data, some 44% (US$291bn) of the US$663 decline in total foreign exchange reserves since the end of December 2015, has been entirely due to valuation effects.”

The chart below, supplied by CBA, provides a visual explanation that the impact of the stronger US dollar has had on the value of China’s FX reserves. As the value of the US dollar index rose – inverted in the chart – the level of China’s FX reserves have fallen.

Unlike some other closely followed analysts who believe that the Chinese banking system is about to implode under the weight of mounting soured loans – something that flared last week following the news Chinese banks extended more credit than ever before in January – Grace suggests that a full-blown banking crisis is unlikely, with the Chinese government well positioned to deal with a likely increase in non-performing bank assets.

“While we are in agreement that non-performing loans should rise, and that they are probably higher than what the official figures suggest, we come to the conclusion that the Chinese authorities are fully capable of supporting China’s banking industry under our bear case of a rise in total NPLs to 15% or CNY11.1 trillion (US$1.7 trillion),” says Grace.

He suggests that bank recapitalisation would not require China to liquidate great swathes of its FX reserves, suggesting the government has three sources available to boost bank capital should the need arrive: new bond issuance from the central government, new share issuance from Chinese lenders to domestic and foreign investors along with a small proportion of the nation’s FX reserves.

Alongside the explanation behind recent weakness in the renminibi, the decline in FX reserves and the ability of the government to deal with an increase in bad debts at Chinese banks, Grace suggests there’s one final reason, likely the most important, as to why China is unlikely to devalue the renminibi significantly: it would crush investor confidence, not only in China but around the world.

He explains.

If the Chinese authorities were to engineer a large 10% to 20% depreciation in the currency, it would risk shaking economic confidence on a much grander scale than the benefits that could be derived from additional net export growth.

The August 2015 “one-off 1.9% devaluation” shook economic confidence not just in China, but across global markets. A much larger 10% to 20% depreciation in the currency would generate a larger shock to confidence. The Chinese authorities want to ensure that the current trend of consumption-led domestic growth continues, and it is unlikely that they would risk that domestic growth transition in order to try and generate net export growth that they haven’t required in the past.

A large 10% to 20% depreciation in the currency would presumably give the impression that something sinister is occurring in the Chinese economy. The outcome would most likely generate a large fall in China’s (and global) stockmarkets and a particularly large fall in global industrial commodity prices. Because China is a net commodity importer, China’s currency would have to fall less than commodity import prices to generate a net benefit for the Chinese economy. There is no certainty this would occur. It is possible China’s overall competitiveness may improve, but at what domestic cost?

The point Grace makes is shared by many investors who do not have a vested interest in spurring market concern, and as a consequence, ramping up short-term market volatility.

Would the benefit of a sudden depreciation outweigh the cost to investor sentiment, and as a result the global economy? The recent 4% depreciation of the renminbi certainly didn’t. If anything, it intensified fears that the global economy was about to enter a recession.

One can only imagine what a 10-20% “sudden” devaluation, or more, would bring.

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