by Angus Nicholson, IG
The largest one-day weakening in the CNY mid-point since August has put China devaluation concerns and a global deflationary crisis front-and-centre in investors minds. The efficacy of China’s new equity “circuit-breakers” has also been greatly called into question, and their days are looking numbered. The Chinese CSI 300 only traded for a total of 14 minutes today before it hit its 7% limit down and trading was halted for the day. The market was halted for 15 minutes after losing 5%, but in that 15 minutes all that happened was traders just fed the market with more sell orders so that as soon as the market reopened it very rapidly hit its 7% limit down rule for the day. It’s difficult to see the “circuit-breakers” surviving long in their current form, given they only seem to be further contributing to the volatility in the Chinese market.
Many people are asking how far Chinese equities could fall. If we look back at other state interventions to prop up stock markets (Kuwait 1982, Pakistan 2008, for example), the interventions propped up stocks at inflated levels and eventually the selloff continued, just at a later date. The Chinese stock market bail out prevented Chinese stocks from finding a natural “floor” where investors genuinely believed stock valuations had returned to a level where they were happy to purchase and hold the stocks. The selloff in Chinese equities we have seen this week only emphasises the point that the stock market intervention may have only delayed the selloff. Of course, direct state intervention, extension of the holding period for stocks bought by the “National Team” are likely to prevent the “true bottom” being found.
In mid-2015, based on inflation-based real exchange rate calculations many concluded that the CNY was roughly 10-15% overvalued. Since the August devaluation the onshore CNY has now weakened by 6.2%. Leaving the door open to a further 3.8-8.8% of weakening before the currency reaches some form of parity to its mid-2015 level. A full 10% weakening since August before a significant pause does look increasingly likely, partly because a 10% weakening from its early-August level would take it to roughly CNY 6.83 – exactly where it traded for a two-year period from 2008-2010. A 15% of weakening would take it to CNY 7.14 – a level it has not traded at since February 2008.
The great concern for global markets is that the dramatic pace of the currency devaluation seems to indicate a far greater weakness in the Chinese economy than is easily perceivable in its publicly released statistics. 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 5.9% year-on-year in November – its lowest level since October 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 250 basis points to 17.5% (I should note the PBOC have also recently announced changes to the way they will manage the RRR in the future perhaps making it less significant as a monetary policy tool). 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 ease the pressures of deflation on the financial system and stop credit completely drying up – leading to a potential credit crisis. And this 5.9% producer price decline will be exported globally through the devalued CNY. This could lead to a major global deflationary impulse.
Prior to the CNY devaluation of the past week, bond markets were giving a more than 50% probability that we could see the next rate rise by the Fed in March or April. The most likely day that we could see it is now being pushed back to is June. And what this means is that a wave of further easing by the Bank of Japan and the European Central Bank could well be in the offing. And the RBA and RBNZ, who are currently set to keep rates on hold, could be pushed towards further cuts.
ASX
The ASX is on track to see its worst one day performance since 29 September, its worst week since August 2011, and worst start to a year possibly ever. The ASX has lost more 2% today.
The selling has been most dramatic in energy stocks, after the oil price plunged to fresh new lows on China concerns.