Monday, 21 June 2010

CHINA Depegs Yuan – Catches markets by surprise….

China’s move to as to de-peg the Chinese yuan (CNY) against the US dollar (USD) caught everyone by surprise. The timing of this announcement is uncanny as it comes a weekahead of the forthcoming G20 meeting. It is intended to take the pressure off at the G20 meeting where this was one of the top agenda items. This is also intended to silence the US lawmakers who have been vociferous in their call to levy countervailing duty as a retaliation to alleged Chinese currency manipulation.

The PBoC issued the following statement on Saturday:
“In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People's Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.

Starting from July 21, 2005, China has moved into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Since then, the reform of the RMB exchange rate regime has been making steady progress, producing the anticipated results and playing a positive role.

When the current round of international financial crisis was at its worst, the exchange rate of a number of sovereign currencies to the U.S. dollar depreciated by varying margins. The stability of the RMB exchange rate has played an important role in mitigating the crisis' impact, contributing significantly to Asian and global recovery, and demonstrating China's efforts in promoting global rebalancing.

The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.

In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.

China's external trade is steadily becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010. With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist. The People's Bank of China will further enable market to play a fundamental role in resource allocation, promote a more balanced BOP account, maintain the RMB exchange rate basically stable at an adaptive and equilibrium level, and achieve the macroeconomic and financial stability in China.”

What does it mean for markets?

This move should be an immediate positive for risk appetite as was reflected in today’s moves in financial markets. There is still potential for trade tensions between the US and China if CNY appreciation is viewed not adequate. However, the initial reaction from the US administration has been positive.

The commodity currencies – AUD, CAD, NOK, BRL, RUB and MYR – will particularly benefit from this, at least, initially. Similarly, Asia ex-Japan (AXJ) currencies should benefit across the board, but particularly those with high correlations to CNY – SGD, MYR, KRW, TWD and INR.

Flexible Fx regime

The PBOC statement clarified that any CNY appreciation will be modest China will not do another one-off CNY revaluation against the USD. In the same breath, they emphasized that
CNY depreciation against the USD cannot be ruled out if the EUR falls sharply against the USD.

This is where, I think, the Chinese authorities have hedged their bets. With the risk of widening European sovereign debt crisis, it is widely expected that the Euro will weaken. This would allow China to either weaken the CNY against the USD or manage the pace of appreciation.

The PBoC statement reflected a delicate balance between the need to reassure the domestic audience – which is worried about exports, jobs and what happens when the domestic stimulus wears off – and the external audience – which has expressed concern at what is perceived by some as a “manipulated” exchange rate. The clear emphasis in the statement was to reassure the domestic audience.

However, the risk is that the Senate sponsors do not accept China‟s move as sufficient and press ahead with the bill, which one Senator has threatened to attach to the Small Business Bill, which is currently being drafted and has wide-spread support.

Economic implications

A stronger CNY is expected to create upward pressure on other Asian currencies, especially Taiwan dollar (TWD), Singapore dollar (SGD) and Malaysian ringgit (MYR). This will imply stable crosses between CNY and other Asian currencies, which mean Asian exporters will stand to get little, if any, advantage via exchange rate competitiveness.

China’s import concentrate in raw material and high-tech capital goods and a stronger CNY should boost China’s demand for such products. For commodities, the expectation of robust demand from China could support prices and the rise in energy, metals and softs could easily more than offset the impact from a stronger CNY.

A more flexible CNY could affect Asia through increased capital flows. If the market is pricing in CNY to appreciate moderately in the long run, international capital flows could return to Asia in search for yield. Further to prospects of currency appreciation, a more sustainable fiscal environment and better growth prospects will continue to underpin its optimism on the region. This could imply that Asian central banks’ worries over asset price bubbles could return.

The global recovery remains on track, led by Asia. Major central banks will likely keep interest rates very low for an extended period to support growth whereas Asian (X Japan) central banks will tighten monetary policy. This should trigger renewed capital inflows into the region which should be bullish for Asia (X Japan) currencies.

On balance, the de-pegging of the CNY should be massively bullish for AXJ currencies even if China moves very slowly during the first months. The Reserve Bank of India’s (RBI) absence from the FX market may also make the INR particularly well placed to gain from CNY de-pegging.

The EUR-USD and GBP-USD will register modest gain initially though the overhang of the European debt crisis will limit any gains and may actually weaken as the debt crisis unravels. This, as I noted earlier, is the hedge against any steep appreciation of CNY.

The coming weeks and months will provide more insight into the basket of currencies against which the CNY is going to be managed. The devil is in the detail! Until then, we will continue to witness some knee jerk market reaction.....

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