Sep-14. Dec-14. Jun-15. Mar-15

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1 SEB FX Ringside 18 August 2015 China devaluation what s next? Latest developments China devalued the daily fixing by a total of 4.6% last week. 1-2% daily devalue may seem tiny to euro investors who see this almost daily, but as you can see from the chart below, this daily change is over 100 time more than usual. In addition, the calculation of the daily fixing has been changed to market makers end of day quotes, making it more market based than arbitrary set by the central bank as has been the case. This is a major shift in China similar to when China joined WTO in 2001 and changed the landscape in the global export market or when China de-pegged from the USD in July 2005 and appreciated over 30% Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 However, over the next week or two, we will see some reprieve. PBoC was adjusting the daily fixing to move towards the market driven spot rate. This gap, as you can see from Chart below is narrowing. The gap was 1.5% at the start of last week but that has narrowed to about 0.05% today. The daily fix has been close to the closing levels of CNY spot and is becoming much more stable than what we ve seen last week. Fixing is catching up to the market rate. The market was in panic mode the last week and with a more stable fixing going forward, be careful of rapid reverse in volatility Sep-11 CNY fix daily change % USD/CNY spot spread to fixing % Dec-11 Mar-12 CNY High Low Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Author: Sean Yokota What is important to watch going forward? Of course we will continue to watch the daily fix and the gap between fixing and spot. However, the focus will slowly shift to market events because now, global events in US and EU will have more impact on CNY. At least on a short term basis, CNY was shielded from global events because of the manipulated fixing. Now, global volatility will hit CNY immediately (both good and bad news). We ll be focusing on how Fed comments and major US data releases like payrolls impact CNY. In addition, Chinese economic data should play a bigger role in determining CNY. Next major release is the flash China PMI but the most important data will likely be the trade data released in the second week of September. Now that fundamentals matter, what is the latest incoming data saying about growth? July data have been weak. We kicked off by poor PMIs (manufacturers sentiment) and exports. More importantly, the biggest driver and weakness in domestic demand is the construction sector and we still see weakness. Our proprietary SEB Construction Indicator is still at the cyclical trough of -17%yoy (Chart below) and the seasonal rebound we typically see in 2H is being delayed % yoy 3mma SEB China construction indicator Sales by floor space Developments are improving where sales and construction completions are increasing. Normally, this leads to developers buying land and new construction starts to rise. However, activity is not picking up because there is inventory overhang in second and third tier cities (Chart below). The good news is that inventory drawdown is taking place, especially in second tier where the red line in Chart is declining. We would need to see third tier inventories fall as well for construction activity to pick up since the inventory level there is almost 4 times bigger than second tier. Chinese domestic demand is still in correction phase. You can also find our research materials at our website: This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained herein without notice.

2 FX Ringside Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 Ripple effect to the world exporting deflation After an almost 5% devaluation by China, there will be ripple effects in the region and to the world. In addition to the currency weakness we ve already seen in Asian economies, we will likely see central banks become more dovish. A weaker CNY means Chinese exports will be cheaper and exporting deflation. Chinese producers may not cut prices and instead take higher margins but that means supply will remain elevated since Chinese producers have bigger profit margin as buffer and still push prices lower. Chart below shows how much China exports inflation/deflation (green line, we use Hong Kong export price index as a proxy since China s data is lacking) and relationship to global prices (blue line, we use US PPI final goods as a proxy since we assume that US has the least distorted producer prices). We think China will continue to export deflation (green line lower) and put downward pressure on global prices, similar to when China went through deflation pressures in early 2000s vacancy houses waiting for sale yoy% % yoy 3mma May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 1st tier 2nd tier 3rd tier -6 US PPI HK export unit value index May-15 IMF doesn t like one night stands - Next steps in liberalization As IMF showed in their handling of Greece, it is not satisfied with one off adjustments. IMF wants to see continuous liberalization than China just adjusting the fixing mechanism. China will likely make another shift before the November SDR decision. The easiest adjustment will be band widening but with fixing more markets based, widening the daily trading band means very little. We think opening the capital account more will be the next step. Specifically, opening the bond market to private financial institutions is the likely step. About a month ago PBoC announced that it will allow foreign central banks and sovereign wealth funds in the interbank bond market and scrapped quotas. We think this will be opened next to private financial institutions, which create bulk of the volatility in global markets. The stickler China s obsession with SDR inclusion Over the past week, investors are most stuck on why China is so obsessed with SDR inclusion by November. While this has been a long term plan by China, many are questioning why. As with many things in the west, we think it is driven by domestic politics on two fronts. First, CNY admission into SDR gives the central bank more power and influence. It raises PBoC s status for getting China into the elite group of currencies. Second, we draw parallel to when China joined WTO in The top leaders wanted to join WTO because the benefits of gaining access to global markets outweighed the political costs associated with lowering tariffs and driving certain local companies out of business. Joining WTO was an excuse to fight domestic constituents who were against reform. The same may be true for SDR where certain groups are likely against making CNY more freely tradable and opening the capital account. But to make RMB an international currency and break free from US dollar dominance and reliance on US economy and monetary cycle, opening up is a price China needs to pay. President Xi would be saying, hey these rules aren t set but are international rules we need to play by to gain monetary independence. My hands are tied. Sean Yokota

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6 FX Ringside FX recommendations B/S 18-Aug Price obj. Stop P/L Start val / Start date FX Forecasts SEB Forecasts Action levels 18-Aug 1m Q3 15 Q4 15 Q1 16 Q2 16 Buy Sell EUR/USD EUR/SEK USD/SEK EUR/NOK USD/NOK NOK/SEK EUR/GBP GBP/USD GBP/SEK EUR/CHF USD/JPY EUR/JPY AUD/USD USD/CAD EUR/PLN EUR/HUF USD/TRY USD/RUB USD/CNY USD/KRW USD/SGD Central Bank forecasts Sweden Norway USA EMU Japan UK Canada Switzerland Base rate -0.35% 1.00% % 0.05% 0.10% 0.50% 0.50% -0.75% Next meeting 03-Sep 24-Sep 17-Sep 03-Sep 15-Sep 10-Sep 09-Sep 17-Sep Action expected -0.10% unch unch unch unch unch unch unch Next change Q4-16 Dec-16 Sep Feb Direction hike hike +25 bps --- QE +25 bps hike ---