January 7 this year will long be remembered by those in financial markets.
It was the day that China’s stock market crashed 7% in just 867 seconds of trade, ending the session prematurely as the regulators ill-fated, and now defunct, circuit-breakers kicked in.
While there are plenty of hypotheses floating around as to why the sudden, record-breaking plunge occurred, one factor above all others stands out – continued weakness in China’s currency.
Sean Callow, currency strategist at Westpac, is one analyst who believes that persistent weakness in the renminbi contributed to the decline.
Callow notes that on that day the PBOC fixed its USD/CNY rate at 6.5646, the highest level since 2011 and on the higher side of expectations that day, contributing to investor nerves that drove the Shanghai Composite down over 7% in less than 30 minutes of trade.
Since that day, described by Callow as a “watershed” moment, the PBOC has been fixing the USD/CNY rate fractionally lower most days, helping to calm markets modestly over the past two weeks.
Despite relative stability in the fixing rate since January 7, Callow is uneasy on whether the relative stability will last, noting that the USD/CNY continues to trade in the upper half of daily trading range implemented by the PBOC.
“We can’t help feeling some déjà vu,” wrote Callow in a research note released yesterday.
“The lowest spot USD/CNY has traded since 7 Jan is 6.5668. Given the 6.5578-5.5637 range for the fixing rate, not a single trade has occurred at the benchmark rate.”
The chart below, supplied by Westpac, shows the gap between where the USD/CNY rate has been fixed and where the spot price has been trading.
Callow notes that a similar situation occurred in the lead up to the August 2015 one-off renminbi “devaluation”, an event that stunned markets at the time as the PBOC announced that it was changing the fixing mechanism to allow market forces are greater role in determining the USD/CNY’s level.
“The chart does of course show that the scale of the gap between the midpoint and spot USD/CNY is much smaller now than in H1 2015, but the paradigm is the same,” says Callow.
“Each morning since 7 Jan the USD/CNY midpoint has been set below the previous day’s close, regardless of the intervening USD/majors price action.”
To Callow, and others, this goes against previous statements from the China Foreign Exchange Trade System, or CFETS, that market forces would play a significant role in determining the value of the renminbi against a basket of currencies.
Quite simply, that isn’t happening.
“The past couple of weeks provide another reminder of the difficulties Chinese policymakers are having moving towards a market-driven currency after so many years of keeping USD/CNY on a very short leash and thereby producing side effects in terms of investment decisions and market positioning,” says Callow.
While confusion over the actions of policymakers continues to undermine confidence, Callow believes that risks for a sharp weakening in the renminbi are growing, particularly given signs that authorities are continuing to fight capital outflows by selling down large chunks of FX reserves.
“Shorter term, it is sensible to expect USD/CNY fixings to hover around 6.56 until further notice,” suggests Callow.
“But any given day holds the risk of a relatively sharp move, with a notably higher USD/CNY the most likely outcome. Hence the risks for the likes of AUD, NZD and Asian currencies around the daily CNY fixings are skewed firmly to the down side.”