Market Bulletin. Chinese yuan: Walking on a tight rope. August 16, In brief

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1 Market Bulletin August 16, 2016 Chinese yuan: Walking on a tight rope In brief Recent trends suggest the Chinese authorities are allowing the Chinese yuan to depreciate against a basket of currencies in an orderly manner. We expect this trend to continue in the medium term, given the yuan s relatively high valuation on a trade-weighted basis. Although this implies future episodes of the yuan weakening against the U.S. dollar, the speed and magnitude of the depreciation will likely be capped by the dollar s own weakness and by Beijing s desire to want to avoid triggering local investor panic. In our view, the Chinese authorities have policy tools sufficient to avoid a currency collapse. We anticipate an orderly depreciation, which poses less of a threat to the global financial landscape than some media headlines have suggested. As in other emerging markets, managing currency risk is a necessity. Yuanbased investors should consider diversifying into international assets to manage their currency exposure. Global investors should manage yuan exposures as well, in order to tap into China s long-term structural growth and income opportunities in its equities and fixed income markets. Tai Hui Chief Market Strategist for Asia Ian Hui Global Market Strategist Investors have been worried this year over the potential for Chinese yuan depreciation, due to its negative impact on global financial stability and role in exporting deflation globally. Alarming media headlines predicting the rapid, disorderly depreciation of the yuan have been replaced by news about Brexit, the U.S. presidential elections and other geopolitical developments; nonetheless, economic data continues to suggest the potential for further yuan depreciation. Here, we address the forces, current and historical, most likely to drive the currency s moves. We believe they point to an orderly depreciation that would be less of a threat to the global financial landscape than headlines suggest.

2 We see the downward bias of the yuan on a tradeweighted basis as Beijing s primary objective. The yuan s rich valuation, relative to its own history, and the prospects of more capital account liberalization in coming years will make China s defense of its currency more difficult and costly. We view allowing the currency to adjust toward a more reasonable valuation is a sensible strategy. Overvalued or undervalued? Exhibit 1 shows that since 2005, when China ended its de-facto currency peg to the dollar, the yuan s real effective exchange rate (REER) has risen by 40%, largely via the yuan s appreciation against the dollar. The yuan s strength has dampened China s export performance in recent years, especially when combined with weak global demand. However, it has allowed Chinese consumers and investors to benefit from cheaper imports of goods and services, and to take advantage of international investment opportunities. The yuan has strengthened against the dollar since 2005 EXHIBIT 1: USD AND CNY REAL EFFECTIVE EXCHANGE RATE (REER) INDEX, REBASED 12/31/2004 = Although Exhibit 1 shows that the yuan is expensive relative to its own 10-year history, whether it is fairly valued remains hotly debated. The International Monetary Fund (IMF) believes that it is; upon completing a review of the economy in June, it stated: the renminbi (CNY) is assessed as broadly in line with fundamentals, similar to our assessment in last year s Article 4 consultation 1. A further indication that a high-speed, disorderly CNY depreciation is unlikely can be seen in Exhibit 2. China s current account surplus has declined from its peak of more than 10% of GDP before the global financial crisis to 2%-3% in the past two years. The accumulation of China s foreign exchange reserve has also started to reverse over the past 2.5 years (Exhibit 5), which adds to the argument that the currency is close to fairly valued based on external positions. China s current account surplus has declined in recent years EXHIBIT 2: CHINA S CURRENT ACCOUNT BALANCE SHARE OF NOMINAL GDP, 4-QUARTER MOVING AVERAGE 12% 10% 8% 6% 4% CNY REER 2% 0% '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 ' USD REER Source: CEIC, J.P. Morgan Asset Management. Data are as of 6/30/ '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 Source: FactSet, J.P. Morgan Asset Management. Data are as of 8/8/2016. Early 2014 marked the end of the one-way appreciation of the yuan against the dollar, reflecting the economic pain from a stronger dollar and domestic slowdown. Since then China has had five significant episodes of yuan depreciation, including the one-off 3% devaluation on 11 August, 2015 (Exhibit 3), unnerving markets and helping fuel fears that similar episodes might follow. 2 CHINESE YUAN: WALKING A TIGHT ROPE 1 IMF Staff Completes 2016 Article IV Mission To China, International Monetary Fund, Press Release No. 16/277, June 14,

3 Yuan depreciation against the dollar in recent years EXHIBIT 3: USD CNY EXCHANGE RATE USD CNY '12 '13 '14 '15 '16 Source: FactSet, J.P. Morgan Asset Management. Data are as of 8/8/16. Focusing on the currency basket In December 2015, the China Foreign Exchange Trade System (CFETS) introduced a new exchange rate valuing the yuan against a trade-weighted basket of 13 currencies. One of the purposes was to reinforce with the market that the yuan is no longer tagged to only the dollar, but to a broader range of currencies. Since its introduction, the yuan has steadily declined relative to this trade-weighted basket (Exhibit 4). We believe this 7.5% depreciation is a deliberate move to improve the competitiveness of the yuan and relieve pressure on the economy. Yuan depreciation against a trade-weighted basket of currencies EXHIBIT 4: CFETS RMB INDEX INDEX August 2015: One-off 3% devaluation 90 12/15 01/16 02/16 03/16 04/16 05/16 06/16 07/16 08/16 Source: FactSet, J.P. Morgan Asset Management. Data are as of 8/8/2016. Since we can assume that Beijing s objective is to continue with this trend, the outlook for the broad dollar is an important determinant of medium-term USD CNY exchange rates. If the multi-year dollar bull market is approaching its end, then the yuan could leverage the dollar weakness to achieve a depreciation against its trading partners. For example, when the USD REER weakened between January and April 2016, the yuan actually appreciated against the dollar by 2%. Hence, China achieved its aim of weakening its currency against a basket of currencies by riding the weaker dollar, but without weakening against the dollar. This dollar yuan relationship is particularly important if, as the market expects, the Federal Reserve is approaching policy normalization with great caution. The implication is that a smaller depreciation of the yuan relative to the dollar will be needed to achieve Beijing s objectives. The imperative to stem currency outflows Further supporting the case for an orderly depreciation is the Chinese authorities awareness that al rapid devaluation of the yuan could trigger further capital outflows. China needs to be mindful of the impact excessive yuan weakening versus the dollar has on investor confidence. Domestic investor sentiment was shaken in late 2015 and early 2016 following successive currency devaluation versus the greenback. This led to increase capital outflows and a sharp fall in China s foreign exchange reserves (Exhibit 5). In the second half of 2015, China s foreign exchange reserves fell by an average of USD 61 billion per month. While this was partly due to currency valuation adjustments, the majority of the decline was due to outflows from the capital and financial accounts. Confidence was restored, to some extent, between January and April as the yuan rose modestly, J.P. MORGAN ASSET MANAGEMENT 3

4 and the decline in reserves slowly an average of USD 2.5 billion per month between April and July 2016 even as the yuan continued to depreciate against the CFETS basket. Stabilization in capital outflow and foreign exchange reserves EXHIBIT 5: MONTHLY CHANGE IN CHINA S FOREIGN EXCHANGE RESERVES USD,BILLONS '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 Source: FactSet, J.P. Morgan Asset Management. Data are as of 7/31/2016. INVESTMENT IMPLICATIONS Chinese authorities possess sufficient policy tools to avoid a currency collapse, but valuation and economic adjustments imply that the yuan is likely to depreciate further, on a trade-weighted basis over the medium term. This should also lead to episodes of weakening against the dollar. We also note some short-term factors to consider. The Chinese authorities are likely to maintain broad yuan stability, both against the dollar and on a tradeweighted basis, ahead of key events such as the G20 Summit in Hangzhou in early September and the inclusion of yuan into the IMF s Special Drawing Rights in October. We saw a glimpse of such window dressing during the G20 finance ministers and central bank governors meeting in Chengdu in July. Yuan-based investors should consider currency exposure in their cash flows and balance sheets and take appropriate action to mitigate currency risks by diversifying into international assets. For international investors, we believe that with appropriate currency hedging solutions, both the Chinese equities and fixed income markets offer means to tap into China s new economy as well as income opportunities. This is particularly important as China s capital markets are expected to become better represented in various important benchmark indices in coming years, opening them up to many more global investors. 4 CHINESE YUAN: WALKING A TIGHT ROPE

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