If the you had to single out the most influential factor in recent rout on global markets, it would almost certainly be the accelerating sell off in the Chinese renminbi.
Its decline last week, the largest against the US dollar since August last year when the PBOC adopted a new yuan fixing mechanism designed to allow market forces a greater role in determining its value, sparked concerns that capital flight from the nation was accelerating, sparking renewed fears of an economic slowdown and, as a consequence, financial instability.
According to Larry Hu and Jerry Peng, analysts at Macquarie, the renminbi’s 1.5% decline last week against the US dollar was due to strength in the latter, rather than weakness in the former.
We believe that the recent RMB weakness was driven mainly by the renewed strength of the USD since last October, rather than China’s domestic factors. In other words, we disagree with the view that the PBoC is embarking on a one-way depreciation. Rather, it’s following the USD. But the PBoC now seems to be willing to accept higher volatility.
Keeping with that theme, Hu and Peng suggest that the performance of the US dollar will largely determine how far, if any, the renminbi weakens in the year ahead.
The most important determinant of the RMB is the trajectory of the USD. If the dollar index continues to strengthen in 2016 like it did in 2015 (up 9%), the RMB could depreciate another 5–7% against the USD. A more benign case is a stabilization of the USD at some point this year, which would help support sentiment and stabilise the currency market, including the RMB.
The pair also suggest that capital outflows from the nation are largely determined by renminbi strength, noting that outflows tend to accelerate during period of renminbi weakness.
Given expectations for further US dollar strength, Hu and Peng believe that Chinese FX reserves, and the reserve requirement ratio for banks, could tumble in the months ahead as the Chinese government ramps up its support for the renminbi.
“Given the strength of USD, China’s FX reserves could decline by another $400-500bn in 2016 and the PBoC needs to cut RRR 5 or 6 times (300bp),” Hu and Peng said.
“The PBoC would intervene in the currency market and step up capital controls whenever it thinks capital outflows are too high.”
In December Chinese FX reserves declined by a record $108 billion, indicating that authorities were actively supporting the currency through widespread, unprecedented purchases.
Clearly the outlook for US interest rates in 2016 will be influential on determining the level of the renminbi in the period ahead.
FOMC members are looking for four hikes this year, the markets two.
Based on Hu and Peng’s view, should the Fed get its way, it’s likely that the renminbi will weaken substantially and, if the price action seen in recent days is anything to go by, lead to heightened and persistent market volatility.
That, in itself, underlines why so many market participants believe that the Fed’s rate outlook is overly optimistic.