The Chinese central bank, the PBOC yesterday announced that the “daily fix” for the official exchange rate for the currency would move from something the PBOC decided each day, which tended to be pretty static, to level incorporating market moves in the daily 2% up or down range that the currency could actually trade each day. It is called moving from a “peg” to a “crawling peg”.
Yesterday the currency immediately traded two percent weaker, and this morning there was great interest where the PBOC would set the FIX and whether it would simply recognise last night’s market close as the true rate, or trim the fall. Market reaction to this has been for the currency to settle at 1.5% down again at 6.43 RMB to the US dollar, at which point it looks as though the PBOC is intervening to prevent further falls.
Why has this happened, and why now.
Because the RMB has effectively been pegged to the US dollar and the US dollar has been so strong, China and its exporters have effectively been getting less and less competitive with other global exporters like Japan, Kora, Taiwan and Germany (see below for the RMB versus the EUR exchange rate, with going down meaning appreciating), all of whose currencies have fallen against the US dollar. Given China, unlike its competitors has significant wage growth, this is especially painful. Set against a weakening economy, something had to be done.
A secondary reason for action reflects Chinese desire to be included in the IMF’s global super currency, the Special Drawing Right, or SDR, which presently is based on a basket of Sterling, US dollars, Yen and Euro. The IMF had pointed to the potentially artificial “official” rate for the RMB as an obstacle to its inclusion, which might otherwise be merited based on its size and significance to world trade.
Where will we go from here?
On equities: the Chinese stock market still seem to feel the Chinese policy makers are behind the curve. This is probably the most interesting area, as everywhere else in the world where rates are cut and currencies devalue, the local markets have rallied in the months after (think Japan 2013 or Europe early 2015).
On Chinese GDP: As there remains widespread scepticism about Chinese statistics it appears that some investors are taking this radical move as evidence that the Chinese growth slowdown is even worse than it appears. This is reflected in the sharp sell-off in many commodities like oil, which has retested recent lows, commodity related currencies like the AUD, and commodity producers like Fortescue.
Other global equities: Global stock markets have reacted oddly. While weakness in exporters to China like Australia, and export competitors like Europe and Japan might have been expected, the sell-off has engulfed the US stock market as well probably more than it should – it is after all just shifting GDP growth from one part of the world to another when currencies move.
The latter is surprising as Chinese devaluation and weaker commodity prices should mean inflation stays lower in the US for even longer than had been expected, reducing the pressure for interest rates to go up as early or as much. This message should sink in that rates are unlikely to move as much
What is likely to come next?
We expect the Chinese policy makers to want to stabilise their markets and their economy. Having moved towards a freer float of the RMB, which we now believe could fall another 10% from here, albeit at a slower rate than the last few days, other policy tools can come into play.
In rough order of usage, and as required we believe these will include:
- Cutting interest rates by another 2%
- Cutting the share of deposits that Chinese banks have to deposit with the central bank by up to another 5%
- Up to a trillion RMB in new fiscal stimulus.
The challenge for China, whose policy makers lack the silky tongue of their counterparts in Europe (hello Mario Draghi) and even the US (Janet Yellen) is to do as little as possible to reignite the animal spirits at home, since doing too much will simply mean a much bigger problem in the future, in terms of potential excess capacity in empty cities and roads to nowhere.
- From a market perspective, we believe that staying short the Chinese Yuan versus the US dollar will stay a robust trade. A central bank doesn’t make such a momentous change in course to stop it 2 days later, we believe.
- We expect US stock markets to settle down – especially if rate and bond markets rally to reflect a slower lower increase in Federal Policy rates.
- We expect Chinese stock markets to find a bottom near here and then rally in the coming months, but we are not rushing to get exposure until we see confirmation this move has started.
- And we expect US rate expectations of a hike, at the margin, to shift to either later, or less, or both.