Caixin View: No Need to Panic Yet Over Yuan Depreciation

The yuan’s steep fall against the dollar that started June 14 has left markets wondering whether China’s central bank is encouraging the currency to depreciate to improve the competitiveness of its exporters amid a looming trade war with the U.S.

The yuan has weakened around 3% against the dollar in the past two weeks, although it strengthened slightly on Friday to 6.6246 as of the official 4:30 p.m. local-time market close from 6.6250 the previous day. The People’s Bank of China (PBOC) doesn't seem to be unhappy about the drop, guiding the currency lower via its daily fixing against the greenback for eight consecutive days starting on June 20. (The PBOC allows the yuan to move 2% higher or lower from the daily fixing.)

The fall reflects concern that China’s economic growth is showing signs of flagging and that trade prospects are deteriorating as the dispute with the U.S. shows no signs of easing. Disappointing data released two weeks ago pointed to a steeper-than-expected slowdown in growth and the U.S. is set to impose import tariffs on Chinese goods starting on July 6. The narrowing gap between Chinese and U.S. interest rates is also putting downward pressure on the yuan, as the PBOC has refrained from moving in lockstep with the Federal Reserve. When the U.S. central bank raised the cost of borrowing by a quarter of a percentage point on June 13, China stayed pat and although it did move with the Fed in the two previous rate hikes, the PBOC’s increases were of a much smaller magnitude.

We think suggestions that the PBOC might be encouraging yuan depreciation in order to improve China’s competitiveness in a potential trade war are unfounded. The central bank has little incentive to see a weaker yuan during what is a critical phase in the crackdown on financial risks. History shows that steep slides in the yuan trigger capital flight and strong capital market fluctuations.

Allowing the yuan to weaken significantly would also be counterproductive to attempts to internationalize the yuan and encourage capital from foreign investors to flow into the country’s bond and stock markets.

Although the PBOC has made little obvious effort so far to prevent the yuan’s decline against the dollar, we doubt it would allow the currency to fall much below the psychological barrier of 6.7 per dollar, a level last seen in August 2017. If the currency breached this level, then we could enter a vicious cycle of depreciation as expectations of further declines would probably increase significantly, putting more pressure on the country’s foreign-exchange reserves and potentially increasing volatility not only in domestic markets but also international markets.

Consequently, we expect some intervention from the central bank, likely in the form of tighter capital controls, if the yuan looks as if it will break through 6.7. We believe the only circumstance in which the PBOC might allow the yuan to go much beyond this threshold is if the depreciation is a good reflection of the dollar’s strength against a basket of currencies, measured by the Dollar Index, rather than a reflection of weakness in the yuan alone.

The real “panic point” for the yuan would be at 6.9 per dollar, which would trigger expectations of further depreciation to the magical 7, a level not seen since the first half of 2008 when the currency was on a strengthening trend. During a previous bout of yuan pressure in late 2016 when the yuan came within a whisker of 7 to the dollar, the PBOC waded in to intervene to prevent the currency crossing what became a psychological red line.

Weekly Roundup

Macro & Finance

In a bid to shore up the economy against headwinds while maintaining a close eye on financial risks, the People's Bank of China (PBOC) announced on June 24 it will allow some lenders to cut the amount of deposits they need to set aside as reserves by 50 basis points from July 5. Yet analysts said the central bank will struggle to balance competing priorities. The PBOC also issued guidelines Monday to encourage lending to small and micro businesses, the latest move to expand financial support for small enterprises.

Downside risks to China’s economic growth in the second half of this year are increasing due to deepening trade friction with the U.S. and slowing domestic demand, a senior policy adviser has warned, urging Chinese authorities to prepare for the worst.

China’s industrial profits jumped in May, the second straight month of strong earnings growth, indicating that profits have stabilized after a rocky start to 2018.

China Development Bank (CDB) says that while some local governments have become more cautious about taking on debt to support shantytown redevelopment projects, the policy lender has not halted loans to support them, refuting multiple media reports.

National Development and Reform Development tells real estate developers to commit in writing to using funds raised through Chinese offshore bonds to refinance maturing bonds. The regulator worries that the scale of foreign borrowing has surpassed the borrowers’ ability to generate profits.

Companies

BYD Co. Ltd. plans to invest 25 billion yuan ($3.8 billion) into quadrupling its car battery output through 2020, despite growing evidence that the electric-vehicle industry is experiencing widespread overcapacity in lithium battery production.

Bad-debt manager China Huarong Asset Management Co. Ltd. issues $1.1 billion in U.S. dollar bonds, the first of several offshore issuances planned in the next 12 months to raise up to $11 billion.

Xiaomi Inc. had a lackluster reception to the first day of retail subscriptions to its Hong Kong initial public offering (IPO), hindered by concerns over its high valuation and weak sentiment.

Jiuquan Iron & Steel (Group) Co. Ltd. has agreed to invest more than $3 billion in a new alumina refinery in Jamaica; the latest in a string of similar projects by outward-looking Chinese metals manufacturers trying to tap developing countries’ infrastructure needs.

China Renaissance Group, a young investment bank with a focus on China’s startup scene that has worked on several well-known tech deals, is seeking to raise as much as $800 million in a Hong Kong listing, Caixin has learned.

Shanghai-listed Fushun Special Steel Co. Ltd. has acknowledged making “accounting errors” on three straight years of financial statements that inflated its net assets by more than 1.77 billion yuan ($269.4 million)by the end of 2016.

DBS Bank, Singapore’s largest lender, is preparing to set up a securities venture in China, becoming the latest foreign company to embrace China’s relaxation of rules on foreign access to financial markets.

Calendar

June 30: NBS releases manufacturing Purchasing Managers Index (PMI), non-manufacturing PMI, and Composite PMI Output Index for June

July 2: Caixin releases the Caixin China General Manufacturing PMI for June

July 4: Caixin releases the Caixin China General Services PMI and the Caixin China Composite PMI for June