China is undertaking a large scale devaluation that could see the CNY depreciate 10% or more over the next 12-months. Even if officially the People’s Bank of China (PBOC) is stating that this is to make the fixing more reflective of the market rate, it is, nonetheless, a de facto devaluation.
The PBOC has come out today saying that they see no reason for the currency to depreciate further and talked down the prospect of a 10% devaluation. However, deflationary pressures and increasingly tight monetary conditions are likely to force their hand again at some point.
Today’s fixing announcement saw a further 1.1% decline from yesterday’s rate-setting. The CNY has now depreciated 3.5% this week, but this rate of decline is unlikely to continue. Towards market close yesterday there were reports of major state banks selling US dollars in the market to slow down the CNY’s decline. While the CNY fixing will take into account the close of the previous day, we may see further direct intervention in the market by state-related arms to pull the currency back to a close that provides a steadier downwards trajectory. After today’s fixing, the CNY has been trading largely unchanged - only up 70 pips. Expect further late-China session selling of the USD in the days ahead to put the close where the government wants it. The CSI 300 has not taken the news well declining 0.9% today, as concerns over companies with US dollar denominated debt weigh down the index.
The PBOC stated that based on their inflation-based real exchange rate calculations the CNY is 17% overvalued. Leaving the door open to a 10% or more devaluation. A lot of people in the market are speculating that this is primarily about boosting exports and stimulating the slowing economy. While this no doubt will help, the primary concern for the government is deflation. Producer prices declined 5.4% year-on-year in July—its biggest drop since 2009. The driving force behind China’s devaluation is to halt deflation and ease monetary conditions.
China’s growth since it introduced an undervalued fixed exchange rate in 1994 has been driven by huge credit expansion and fixed asset investment. As capital flowed into China over this period, China’s FX reserves grew to record levels, leading to phenomenal growth in the money supply. This growth machine was contingent on continued capital inflows and growing FX reserves. As soon as these stopped China was faced with tighter monetary conditions and restricted credit growth. This turnaround happened in June 2014, since then FX reserves have declined 8.5% to US$3.65 trillion. As liquidity in the banking system tightened, China began to suffer dramatically increased deflationary pressures. China’s producer prices have been declining since February 2012, but took a dire turn since China’s FX reserves began to decline in June 2014.
Since FX reserves began their decline, China has been forced to steadily inject liquidity into the system, and have cut RRR rates by 150 basis points to 18.5%. However, it is impossible to continue to ease monetary conditions without a concomitant devaluation in the currency. The Chinese system needs a sustained devaluation of the CNY to stop credit completely drying up—leading to a potential credit crisis. This 5.4% producer price decline will be exported globally through the devalued CNY. This is the beginning of a major deflationary impulse that will be felt worldwide, possibly pushing back Fed and BOE rate hikes and leading to stepped up easing by the ECB and the BOJ.
Koichi Hamada, advisor to Prime Minister Abe, has already come out today and said that Japan can offset CNY devaluation by further monetary easing. And the BOJ minutes out yesterday showed there were significant concerns by BOJ board members about hitting the 2% inflation target by September 2016. With deflationary pressures from the CNY devaluation, there is going to be a high likelihood of further BOJ easing to stop an increase in the yen, possibly as soon as October. This may be one of the drivers that has seen the Nikkei up 0.42% today. Other slowing Asian economies, such as Korea and Thailand, may also take the CNY devaluation as an excuse for further easing.
Gold is also likely to be a major winner out of China’s moves. With gold touching new lows in July and looking oversold on a range of stochastic and technical measures, CNY devaluation could be the boost it needs. With Chinese investors burnt in the stock market, the property market no longer growing at record levels and now faced with a rapidly depreciating currency, there will be increased demand for non-CNY assets that will hold value. Gold is already up 2.8% this week, and there could be further to run. Silver, foreign property, and possibly even Bitcoin could also rally on similar sentiments.
However, markets today are taking the fixing news far better than yesterday. The PBOC’s opaque communications policy may well have led to panic over-selling earlier in the week. Markets have now digested the prospects of a CNY devaluation and are judging it as not as big of a risk as earlier. This has certainly been helped by the CNY holding relatively steady around the fix today, but it is uncertain how much this has to do with direct state intervention in the FX market.
The ASX closed down -0.6% yesterday year-to-date breaking below its 2012 uptrend, with energy and resources stocks taking major hits over concerns about the implications of a CNY devaluation. However, sentiment has turned around today with the index up 0.75% today.
Australian earnings continued, with Fairfax Media Ltd (ASX:FXJ) seeing a 7% rise in its stock price after beating underlying earnings expectations. Underlying earnings still declined 3.9%, but its decline was minimised by a strong performance from its property listings website domain.com.au. It seems FXJ is strangely increasingly exposed to the continued success of the property market in Australia.
Telstra's (ASX:TLS) earnings also came out today largely in line with expectations. There was a bit of confusion due to its sale of CSL in Hong Kong, which impacted its underlying earnings. Underlying earnings were actually up 6% once the sale of CSL in 2014 was accounted for. Nonetheless, TLS was down 1.7% today over concerns that it needs to make further acquisitions to stop a decline in earnings. Telstra has already invested in a range of sectors including healthcare, and it may be considering other purchases in Southeast Asia and India after its Indonesian joint venture Telekom (NYSE:TLK) earlier this year.
Iron prices have ticked up, with Dalian iron ore future up 1.7% today. This may be partly due to the explosion at Tianjin port overnight, which may have upset supply distribution networks. Miners have largely recovered from their big losses yesterday, as the market digests the new Chinese fixing regime, and iron ore prices are pushed up on distribution bottle-neck concerns.