While it has found some renewed strength over the past 24 hours, investors the world over have been focused on the continued weakness of the Chinese renminbi.
Last week alone the USD/CNY weakened by 1.56%, extending the losses for the renminbi to over 6% since mid-August last year.
The accelerated sell off, sparking fears of financial stability, capital outflows and weaker economic growth from the world’s second-largest economy, saw risk assets crater.
Stocks and commodities were hammered while currencies closely aligned to the performance of the Chinese economy – such as the Australian dollar – were pulverised into the abyss.
Demonstrating this point, against the US dollar, the Australian dollar fell 4.73% last week, the largest percentage decline since September 2011, the height of the European debt crisis.
While there is already debate as to how far, if at all, the Chinese renminbi will weaken against the US dollar in the year ahead, Westpac’s Robert Rennie suggests that continued weakening in the renminbi will present a trifecta of trouble for the Australian dollar.
Rennie cites three reasons behind his call: that it will likely increase financial market volatility, place further pressure on commodity prices and potentially lead to capital outflows accelerating across the Asian region.
He suggests that the PBOC’s move to base the renminbi’s exchange rate on a basket of currencies, rather than just the US dollar, has contributed to the recent bout of financial market volatility, especially in currency markets.
If China is focussing on “guiding the public view of the RMB exchange rate based on a basket of currencies” then that means that the nature of fix models is changing. However, the sheer size of the error and the speed with which it is swinging is a huge source of volatility for FX markets in my view. In effect, it suggests that the daily fix has become much more ‘random’ event at least versus pre-August, and that tends to increase volatility in global markets.
Along with the increased volatility around the PBOC’s daily USD/CNY fix, Rennie suggests a weaker renminbi will also heap further pressure on already beleaguered commodity prices.
“China has been a source of deflation for the global economy for many years now. In a world where central banks are fighting to create some inflation, that is a problem. A sharp yuan devaluation adds to that problem,” says Rennie.
He uses Chinese steel prices to demonstrate this point.
Cold rolled steel prices in yuan fell 31% last year. In USD they fell by 34%. While prices did stabilise and even bounced a bit into the end of the year, a sharp drop in the yuan depresses steel prices around the world. It also makes the cost of the inputs into steel more expensive for Chinese steel producers and commodity markets have clearly taken last week’s developments poorly. Copper, for instance has slumped to fresh lows back to May 2009 sub $4500 and WTI crude has dropped to $30.88 and at some point in coming weeks is at risk of a $20 handle. Commodity price weakness has been a key factor behind the 4% fall in the A$ so far this year.
The third component of the “trifecta of trouble” is the direct impact of capital flows in and out of Asia.
“A period of messy China devaluation has a direct impact on capital flow into the Asian region, says Rennie.
“The intense capital flow into Asia that took place over the 2012/13 period reversed late last year and looks like it has continued early this year. This has important implications for Asian equity market demand.”
The chart below, supplied by Westpac, reveals the recent decline in capital flows to Asian equities.
As a consequence of these declining capital flows from outside of Asia, which are heaping pressure on Asian currencies, it has also led to Asian central bank FX reserves falling sharply as authorities intervene to defend their currencies.
While Rennie suggest that continued renminbi weakness will weigh on the Australian dollar should it eventuate, he doesn’t share the view of others that the currency is destined to plummet, suggesting that a hefty queue of M&A deals announced in the last 12 months should continue to support the Aussie.
“All up I think events in China have shifted AUD to a new 0.68 to 0.72 range but that the lower end of that range will remain sticky as equity related demand builds,” says Rennie.
“This flow will continue to frustrate the more bearish forecasters out there.”
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