China is going to devalue further

The PBOC appeared to reassure market yesterday that its devaluation intentions are modest. Here’s Goldman:

The PBOC press conference held this morning followed the recent sharp sell-off of the RMB as well as heightened market uncertainty about the implications of the reform to the CNY fixing mechanism introduced on August 11. It was attended by Deputy Governor Yi Gang and Assistant Governor Zhang Xiaohui.

The PBOC officials said that the main reasons for the reform are the need to correct the pent-up misalignment of the exchange rate (including from depreciation pressure created by a period of loose liquidity conditions) and the structural goal of transitioning the previous de-facto USD peg to a managed floating rate system. Notably, they did not mention the need to boost growth as a main reason, and also particularly ruled out the need to stimulate exports through a large (10%) depreciation.

Importantly, while the officials said that they would not comment on what the equilibrium exchange rate level is, they said that the misalignment had been about 3%, citing “market survey and analysts’ general estimate” (although it is not known who was covered in the sample), and the roughly 3% depreciation since August 11th has already largely removed this misalignment (it is unclear what the 3% depreciation referred to, but possibly the closing spot rate yesterday vs. the closing spot rate on the 10th). They emphasized that solid fundamentals (e.g., strong trade surplus, abundant FX reserves) would continue to support the currency, and they expected the exchange rate would remain on a broad appreciation path in the future. They reiterated their long-term objective of increasing the market-orientation of the CNY regime.

We think the clearest signal from the statements is that further sharp CNY weakening has become much less likely. While we think they will continue to follow closely the new fixing mechanism (i.e., setting CNY fixing close to the closing spot price of the previous day), the PBOC will now likely start relying more on open FX operations as needed to manage market expectations and curb large depreciation in the near term. The strong policy guidance from today’s press conference, though, may in any case help reduce the need for FX operations for expectation management going forward. Coincidentally, it is interesting to note that the spot exchange rate appreciated suddenly by about 0.5% and converged to the fixing around the beginning of the press conference, although it is not known whether it was a result of PBOC operations or market’s reaction to the PBOC’s statements. We think it is likely that from this point on, the principle of maintaining a broadly stable CNY NEER will be a main (but not the only) factor guiding the USDCNY movement.

Regarding domestic monetary conditions, the officials emphasized that liquidity is ample and interest rates are stable. We think that signals against a major reduction in interbank interest rates. We think, however, broad RRR cuts are still likely, especially as they would be an effective way to replace the liquidity drain related to possible PBOC’s FX operations in recent days (and potentially days ahead).

That’s if you believe the PBOC. Seems to me it’s simply handing the devaluation job off to markets. Widen the band, set off a devaluation, sit back and watch as capital flight does the rest. Investing in Chinese Stocks captures the strategy:

A debate is raging over whether the PBOC or the market is driving the yuan exchange rate. It’s clear to me that the market wants to take the yuan lower and will take it much lower if allowed. The PBOC can claim the market is setting yuan’s price in order to avoid being charged with manipulating the currency. What happens when they don’t want it to fall anymore? Do they stop moving the fixing lower and show they are indeed in control? What happens if they stop devaluing CNY and the market decides to take CNH lower anyway?

The Informational Power of the Offshore Yuan Exchange Rate

Empirical results suggest that (i) developments in the offshore spot market could influence the onshore spot market in terms of both level and volatility during a period of offshore market dislocation, and (ii) the onshore market drives price movement offshore under normal market conditions, while developments in the offshore market could still affect the volatility of price movement in the onshore market.Normal conditions, aka when models work. What happens in the periods when markets experience great volatility, change their pattern of behavior and even move to new equilibriums?

We can also find evidence that, despite wide-raging capital controls on flows between onshore and offshore markets, developments in the offshore market could influence onshore markets through volatility channels. Given that volatility in the offshore market has been higher than that in the onshore market, these findings imply that offshore market developments should be monitored carefully, as it could impact exchange rate stability on the mainland. In addition, during a period of offshore market dislocation, developments in the offshore market could influence the onshore spot market in terms of both level and volatility possibly because market participants believe that price development offshore better reflect global market conditions.

China knows how to say one thing and do another better than most. It’s superb real politik in action, using markets against the West to disguise currency warfare. The yuan is very likely going to devalue further and the intention is to boost tradables growth. Nothing else makes much sense. UBS offers a Q&A on the outcome:

Question: Will the weakening of the RMB lead to greater capital outflows from China? Could you give me your view on capital outflows?

Answer: One of the reasons that the authorities don’t want the currency to move too fast is that it might generate its own momentum, encouraging capital outflows. I don’t think that’s something the authorities would want to encourage. So, in other words, the process will be managed so that it doesn’t generate significant capital outflows.

I think capital outflows would really depend on the trajectory of currency depreciation. The local A-share market has lost its charm to many domestic investors. It means capital outflows are, I think, kind of inevitable. But massive capital flight could only happen when currency depreciation is very sharp. In such a case, not only will domestic investors convert RMB to foreign currencies, but many global companies will also repatriate their cumulative profits back home. They have operated in China for years but, due to capital account restrictions, usually select to harbor most profits in China. So if – only if RMB depreciates suddenly by 10% or more, would I expect these multinational companies to start repatriating capital.

My guess is that very sharp depreciation, like 10% within one or two quarters, will trigger serious capital flight.

Question: I have a number for capital flow: for every one percentage point of RMB depreciation, the impact on capital outflow would be about $40 billion so I just want to know whether this number is roughly correct. And also, for every 100 basis points RRR cut, what would be the liquidity injection to the domestic market?

Answer: Capital outflow has definitely increased since mid last year, partly driven by expectations of RMB depreciation and one important mechanism of that was the unwinding of foreign exchange liabilities that was built up in the previous episode of strengthening RMB expectations. When everybody was expecting RMB to appreciate, people borrowed from offshore or basically gained FX exposure offshore to bring the liquidity home. A lot of that was short term, trade credit and so on. Now, with expectations changing, this is reversing. But, as of second quarter, this outflow had actually started to stabilize; outflows are no longer that big. So as for your question – how much will this trigger? I don’t think you can have a one on one relationship of 1% depreciation leading to $40 billion; that’s probably some correlation based on short term data rather than causality.

Directional wise, depreciation could become entrenched if people expect further depreciation, now that could actually facilitate further outflows, even if that took place in just companies paying down their foreign debt more quickly. So that could happen and that’s why we say, directional wise, it could tighten domestic liquidity. The Central Bank, of course, can use various liquidity facilities, including RRR cuts, to offset it. A 100 basis point cut in RRR would release liquidity of 1.2–1.3 trillion RMB.

Question: In terms of the export sensitivity, for every 1% of RMB depreciation, what would be the positive uplift for exports?

Answer: On the price elasticity of China’s exports – many people have done estimates on that and generally they take it as one on one, meaning that a 10% depreciation leads to a 10% change in export price, that leads to a 10% change in exports. However, it’s very much up to the exporters in how much they transmit that exchange rate movement to their pricing. For example, in the past, we have noticed that they don’t pass all exchange rate appreciation through into more expensive prices. They pass on only part of it, which means that they actually squeeze their own margins. So in this respect, when China’s currency depreciates, they could do something similar to widen their own margins, rather than completely passing on cheaper Chinese export prices to consumers.

On the benchmark – as I said, if Chinese exporters pass on all depreciation effects it could translate into a 1% uplift for exports, but in reality it will probably be more like 0.5%. So a 1% depreciation, could help 0.05% of exports.

Question: Could you actually shed some light on the impact of the weaker Chinese yuan on the prices of commodities, such as coal, natural gas and oil, maybe?

Answer: So on the linkage to commodity prices, I think the biggest driver of commodity prices, of course, are China’s demand and their supply situation. That said, I think if the Chinese currency weakens to the extent that demand from other countries for commodities will also weaken, this will be considered as somewhat of a negative.

Question: What will be the impact of the weaker Chinese yuan on domestic interest rates?

Answer: As I mentioned, we don’t think it would inhibit another rate cut. Traditionally people would say that because the Fed is about to raise rates and because its currency is weakening, the Chinese government may not have much room left to cut rates. But in our view, actually, given that: the domestic economy needs help and that the real interest rate level is still very high domestically; the government still retains some control on capital flows; and inflation is still very low — I think they still have room to cut.

Yes they do and they will have to. Capital flight will tighten local credit conditions in a financial system used to operating with a capital account glut.

Brace for more devaluation.

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