Friday, August 14, 2015

The Chinese did what was inevitable but still came as a surprise to the market – they devalued the renminbi against the dollar

The Pressure Tells

·         China surprises the market by devaluing the renminbi

·         Chinese authorities will position the change as structural

·         Massive portfolio outflows appear to have pushed the Chinese to act now

·         The surprise shift in policy only encourages investors to remain risk averse

·         The Fed may still move to increase interest rate in September

·         We continue to advise investors to remain risk averse and biased to bonds

What has happened?
The Chinese did what was inevitable but still came as a surprise to the market – they devalued the renminbi against the dollar. The devaluation has taken the form of adjusting the reference rate against the dollar, 1.84% higher on Tuesday and a further 1.6% higher today, Wednesday. We believe the currency is at risk of further downside. In a break with the past, the authorities will going forward set the reference rate closer to the market traded rate. This latter move is a form of structural change which will be welcomed over the longer term by the market. For the moment the markets are trying to come to terms with the shock of what has just happened.

Although the authorities say that the currency adjustment is a one-off given the state of the economy and the significant amount of hot money that has sat in CNY denominated products sold to foreign investors we believe there could be further downside.

One of the catalysts for the devaluation is the ongoing capital flight from China. Charts 2 shows that monthly portfolio flows from foreign investors turned very negative at the end of 2014. Except for one month this year, outflows have continued. Since the data series began there in 2009,  a net $474 billion of foreigners’ portfolio flowed into China, however in June alone $47bn left the country. The currency devaluation may precipitate even further outflows.

Why did they do it?

On first blush it doesn’t seem absolutely clear what specifically the Chinese authorities are trying to achieve with the move to a more flexible currency regime. Was it to make their exports more competitive to help growth? Exports have been weak but this weakness may be as much a reflection of weak global growth as it is about a loss of competitiveness of Chinese exporters. The Chinese must also have been aware that many Asian countries would move to maintain the status quo by letting their currencies fall back too.

The move could be seen in the context of ongoing economic reform. The new process around the reference rate is more transparent and certainly takes the country in a direction that would find favour with the IMF. However, it seems a little odd to make a structural shift in your currency management at a time of such marked weakness of the Chinese economy.

It appears that the authorities have had to respond to the capital outflows by letting their currency fall back rather than buying up all of the capital outflows. The volume of selling was just too big to cope with. The decision to let the currency slide was therefore rolled into a structural shift in the way in the hope that the impact would be more muted.

What happens next?

Despite the new flexibility in the renminbi currency regime we suspect the authorities will not be happy to see the reniminbi slide too sharply. Some intervention might be expected if the slide continues to be aggressive. The challenge for the authorities will be the potential scale of the outflows. As we said earlier there is potentially as much as $400bn of hot money from foreign investors still in China. It would be a surprise to see all of the hot money repatriated however the shock for investors of seeing the break from the previous safe haven nature of the reniminbi probably means it will be some time before we see foreign investors returning to the currency.

The reniminbi weakness will undoubtedly be good news for Chinese exporters. It is often forgotten that the government remains pro-exports with its programme of “One Belt, One Road” initiative.  The country is aiming to sell high-value equipment such as high-speed trains and renewable energy equipment.

Events in China have sent another shock through emerging markets.  Amongst the BRIC countries only India stands out as somewhere we a modicum of positive news. Asia has been rocked by the devaluation of the reniminbi and it has set off of a wave of weakness in other Asian currencies.  For the moment the scale of the Asian currency depreciations is insufficient to create a wave of inflation fears that could translate into early rises in interest rates. Hence we see this as a transitory crisis.

The risk of a rise in official interest rates by the Federal Reserve in September must have fallen. Such a view has already been discounted by and large by the market with a fall in the 10 year yield to below 2.10% and a two-year yield at 0.65%.

Events in China have limited near term implications for the MENA markets. However the China currency crisis has taken many of the equity markets back close to important supports which if broken could precipitate 5-10% downside. The devaluation also serves to highlight that for those countries that peg themselves to the dollar and yet are not able to mirror too closely the momentum of the US economy they will suffer. Luckily the GCC countries are by and large generating growth better than the US and hence are much less vulnerable to the current challenges in global markets

The fall in the renminbi has precipitated another risk-off phase for global markets. To us events in China are just another manifestation of the troubles in the global economy with too little growth and policy makers struggling to get sufficient traction with their policies to reinvigorate global growth. We continue to advise investors to have a bias to bonds and to only buy equities that offer yield or have good long term growth opportunities such as healthcare and technology.


No comments:

Post a Comment