The timing of the depreciation of the CNY last week followed shortly after the publication of the IMF’s review of “Method of SDR Valuation – Initial Considerations”. Discussed quite prominently in the document are the operational implications of including CNY in the SDR (special drawing rights) basket. Key issues mentioned include how to identify suitable representative exchange rates and the timing of those marks. The existence of the official fixing which is quite different than the market transacted rates and the deviation between offshore and onshore exchange rates were noted to raise potential concerns.
While many commentators in the past week have formed a narrative about this latest Chinese move via the lens of currency war or competitive devaluation, we believe the primary motivation of the policymaker remains focused on joining the SDR club. When one browses through the various PBoC press statements following the move initiated last Tuesday, one can find the axis of discussion revolves around issues raised in the IMF document (see link above) down to the fixing rate determination, extension of trading hours and narrowing the offshore/onshore gap. Subsequent press conferences and interviews further reiterated no intention to pursue depreciation as a policy and fundamental factors such as high growth, favorable balance of payments and demand for CNY assets are supportive of the currency.
One needs to also consider in the context of the USD move and the semi-peg CNY experienced in the past 12 months. In both NEER and REER terms CNY has markedly appreciated along with the DXY (charts below) to the tune of 15%. Some alleviation of this pressure is necessary and by migrating to a less managed/more floating regime allows policymakers to be more flexible in regards to monetary policy. This move last week by the PBoC should reduce future gap moves and introduce more two-way volatility. This will hopefully have the side benefit of instilling more risk management discipline to foreign currency Chinese borrowers to hedge appropriately and reduce structural FX carry trades.
Given the expected forthcoming rate hike by the Fed and brighter prospects in the US, the broader USD strength will likely persist. However, China should remain one of the less dirty shirts considering the relative macro indicators from the rest of developed market and emerging market countries. We are cognizant that depreciation pressure on the rest of Asia has increased as a result and recent rhetoric suggest some may use the Chinese move as an excuse to encourage further depreciation of their currencies.
On Chinese growth, we do not expect this move to have material impact and that more will need to be done from the fiscal side to stimulate. Local government and infrastructure spending should be prominently featured in the second half of this year as we have written earlier in this blog.
While local interest rates have risen since last week, we attribute that to the PBoC intervention in the FX market to stabilize excessive depreciation expectations which has led to a temporary absorption of liquidity. We expect further cuts in RRR and open market operations are in order to bring back the conditions to an accommodative level.
Lastly we remain overweight in China USD credits. While there might be concerns about currency mismatch in liability, the overall percentage is not alarming. While we are vigilant on those issuers that might be vulnerable, we also want to note that the onshore CNY market has been open and active for issuers while providing a lower funding cost vs USD markets. This is anticipated to bring down USD bond supply for a better technical picture.