Over the weekend, the People’s Bank of China widened its yuan-dollar trading band to 2%, from 1%.
While this is an important step towards internationalizing its currency, Bank of America’s David Cui points to the market implications of the reform.
“The knee-jerking market reaction may be to speculate on such a move given China’s over-capacity issue (exports is a convenient way to address the problem),” writes Cui. “So in the short run, we expect the impact on the market to be largely negative.”
First let’s take a look at the negative implications:
- While the yuan-dollar band widening is a positive for China in the long run, in the short term it will be a negative for the stability of the financial system. “The widening most likely will promote more hot money outflow in the short run given how unsettled the markets have been lately. This will probably make PBoC’s liquidity management more challenging over the next few months.”
- Banks, developers, and construction sectors are likely to take a hit as outflows suggest property demand will decline.
- Commodities and copper will see a negative impact. “A weak Rmb may also force many commodities carry- trades, most popular in copper, to unwind. The psychological impact can be quite severe in light of the market’s concerns over China’s growth outlook.”
- Importers and foreign exchange debt holders will be hurt by a weaker yuan.
- Finally, it’s a negative for luxury retailers and international tourism as they become more expensive.
This will however be positive for exporters as it would make their good cheaper and for Macau, “until the government cracks down on money laundering.”
Remember this is however in keeping with the promise made during the third plenum to let markets play a bigger role in resource allocation.
Summarizing from the Chinese central bank’s statement, Standard Chartered’s Stephen Green reiterated that this move would allow for greater “price discovery and more efficient resource allocation.” He added that it would “deepen the breadth and depth of the onshore markets.”
Meanwhile, we’ve pointed out that the more meaningful reform that China needs to undertake involves relinquishing control of its exchange rate by moving away from a daily fix.