When the Fed says “jump”, PBOC answers “how low”

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I have described at length the troubled relationship that exists between the a rising US economy and dollar and falling China and yuan. This is the complete reversal of the post-GFC Chimerican global growth model that supercharged capital flows into China, super-charged its investment build-out and super-charged commodity prices. When the divers reverse capital flows out from China, investment falls and commodity prices tumble. It was these dynamics that led to the Mining GFC dislocation early this year and subsequent push back on Fed tightening.

Well, Fed tightening is back today, in theory, and what does the PBOC greet it with? You guessed it, a falling yuan:

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We’re only a few pips above another new low on the CNY/USD cross and why wouldn’t the PBOC let it go? From the WSJ:

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Already, there are signs that outflows are accelerating again amid recent yuan weakening, after having slowed earlier this year. A net $55 billion left China in July, according to Goldman Sachs Group Inc., compared with an estimated $49 billion the previous month.

Beijing’s challenge is how to continue letting some air out of the yuan without triggering excessive outflows and market instability.

Ms. Dissaux of Millennium Global said she believes the market is underestimating the risk of yuan depreciation against the dollar. Investors in the yuan forwards market now expect the yuan to weaken by 2% over the next 12 months, down from 7% earlier in the year.

Strategists at Bank of America Merrill Lynch said in a recent note that the yuan remains vulnerable to renewed capital flight.

Yet even skeptics agree the timing of any market shift remains hard to predict.

“The Chinese will do everything in [their] power to maintain domestic and external stability” in the lead-up to the G-20 summit in early September and the yuan’s accession into the International Monetary Fund’s official basket of reserve currencies in October, saidEswar Prasad, a former top China hand at the IMF. “It’s unlikely for China itself to be a source of instability at least for the next three to four months.”

The real test will come for China’s yuan and its exchange-rate policy when the market starts to price in more aggressive Fed rate increases and the dollar resumes its upward march, investors say.

That’s one to look at it. The other is to reverse the causality. If the PBOC does not want the Fed to tighten, it need only let the yuan fall a bit faster and send markets into a tizzy over tumbling commodity prices…

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.