The CNY has depreciated significantly against the USD in recent months, falling to its lowest level for a year on Friday last week.
What has happened?
On Friday morning, the People’s Bank of China (PBoC) had reduced the currency’s reference rate against the USD by 0.90%, the largest such move in two years. As of July 23, USD/CNY was at 6.79, a depreciation of 6.60% against the USD since end-May this year. Recent falls have reversed gains made earlier this year, with the CNY down 4.00% against USD year to date. CNY depreciation has been accompanied by a decline in China’s stock market. China’s A-share market has declined 7.20% since end-May this year, and 13.50% year to date. Hong Kong’s Hang Seng Index has declined 8.30% since end-May and 5.60% year to date.
While some may see CNY weakness as evidence of deliberate policy to use currency depreciation to offset the impact of tariffs, we think that it is not the case. Using depreciation to counteract trade tensions and imposed tariffs is a dangerous game. We think that the Chinese authorities will be well aware that while a weaker CNY might give Chinese exports some temporary price advantage, it also carries substantial risks. In China’s case, the key risks are probably to market sentiment related (as discussed below) and capital outflows. We therefore believe that the Chinese authorities will want to avoid a sustained currency weakness.
We think that, aside from escalating trade frictions with the U.S., the following reasons are in fact the real drivers of recent currency weakness.
1) Economic slowdown in China. China’s industrial production growth was 6.00% YoY in June, weaker than market expectations of 6.50% and growth 6.80% in May. The slowdown in June was mainly caused by slowing infrastructure investment in China amidst the government’s ongoing deleveraging efforts.
2) PBoC policy loosening. The two symbolic RRR rate cuts in April and June this year were clear indication of a shift in PBoC policy from a tightening to a loosening bias. This also contrasts with Fed tightening, thereby amplifying CNY weakness. Besides, we recently have seen new guidance from the PBoC on how its medium term-lending facility should be used by banks to stimulate lending (and, for the first time, buy high-yield bonds). A further increase on the credit side as well as other sorts of policy stimulus are likely, either through specific directives or more general measures such a further cut in the reserve requirement ratio.
The recent CNY depreciation could be seen also as a contributor to Chinese stock market falls in recent months through the sentiment channel - in this case, due to the growing uncertainty around the trade dispute and economic fundamentals.
Looking ahead, we do not expect further sustained CNY falls. We think that the CNY will stabilize in the coming months and then gently appreciate. This will be due to the following reasons:
1) Reduced economic slowdown concerns. Market concerns over China’s economic slowdown are likely to soften, as the Chinese government increasingly supports the economy with easier monetary and even fiscal policies. We think that the Chinese government may even start to loosen its tightening over infrastructure investment in H2 this year. We still expect the Chinese economy could achieve a soft landing in H2 this year.
2) Government beliefs. As discussed above, any substantial further depreciation from here is not in the interest of Chinese government, as it could create market volatility, excessive capital outflows and a further loss in investor confidence. We think China’s PBoC still favors a stable currency in the current volatile external macro environment.
3) Trade negotiation needs. Chinese government may take a more accommodative approach ahead of negotiations on trade issues with the U.S. They may not want to prejudice negotiations through any further CNY depreciation – an obvious bone of contention for the U.S.
4) Strong external surpluses. The Chinese current account surplus could remain resilient in H2 this year, with China’s export growth as yet relatively little affected by the trade tensions. Positive current account surplus would support CNY.
Our three-month USD/CNY target is 6.65, which represents around a 2.00% appreciation against USD from the current level of 6.79 as of July 23. Our 12 month forecast remains at 6.50.
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