China-related currency risks: who is most vulnerable?

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Cameron Howard
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1 1 Sep 15 Weekly Economic Briefing Emerging Markets China-related currency risks: who is most vulnerable? China s unexpected decision to allow its currency to depreciate on August 11 has intensified global currency risks. Currencies most at risk of weakening in the months ahead include those of countries with large trade links to China, weak fundamentals and especially high sensitivity to global commodity prices. The major currency most vulnerable is the Australian dollar. Among emerging countries,, South Africa and Malaysia are among those in danger. There has already been a sell-off in many currencies in the wake of the China devaluation but this is not necessarily the end of the story. China s economic slowdown may yet have further to go, and the danger of further currency depreciation in China is quite significant. In addition, some emerging countries such as Argentina have yet to see the China effect impact on their currencies but are likely to. So far, trade links to China have not correlated well with currency moves since August 11. This in part is due to many of China s closest trading partners having large current account surpluses and managed exchange rates. Current account positions also help explain other recent features of currency markets such as the strengthening of the euro and yen and the poor performance of the Turkish lira. China devaluation raises FX risk China s unexpected decision to allow its currency to depreciate on August 11 was a shock to world financial markets generally and has intensified global currency risks. Both advanced and emerging currencies have been significantly affected, with measures of currency volatility rising. China and emerging currency index Index, Dec 3 1= OE emerging currency index (LHS) CNY/$ rate (RHS) 7 Aug-1 Dec-1 Apr-15 Aug-15 Source : Oxford Economics/Haver Analytics CNY/$ So far, China s depreciation has been small, at around 3. But this modest move nevertheless set off a chain reaction of currency moves elsewhere. Our OE emerging market currency index (based on 17 major emerging currencies) has declined by 3.5 since August 1, reinforcing a miserable existing trend that has seen the index slump by 1 in the last year. World: Exchange rates versus dollar change in exchange rate versus US$ since August 1 Japan Eurozone Switzerland Argentina Canada Philippines UK China Ukraine Australia Russia Turkey South Africa Malaysia Source : Oxford Economics/Haver Analytics Some emerging currencies have fared rather worse than this: the ian real, Malaysian ringgit and South Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 1

2 1 Sep 15 Emerging Markets African rand have slumped 7-, and the Russian rouble and Turkish lira by about. There have been some big moves among the advanced economy currencies as well. The Japanese yen has gained over versus the dollar and the euro put on as much as 3 at one stage. Meanwhile, the Australian dollar has fared badly, declining by over 5. and risks remain What factors have caused this pattern of currency performance, and what do currency risks look like going forward? In our view, China s devaluation has increased investor concerns about Chinese growth prospects and caused investors to reassess the economic outlook in other emerging markets (EM) also. So there has been a downward re-rating of EM assets, with countries thought to be most vulnerable to the Chinese slowdown among the worst losers. World: Equity volatility VIX index Source : Oxford Economics/Haver Analytics Investors have become more concerned about the broader global growth outlook too, as evidenced by widespread and significant declines in stock markets in advanced economies and the sharp rise in equity volatility, to the highest levels since the Eurozone crisis in These factors have created a classic flight from risk to safe haven advanced economy currencies such as the yen, euro and Swiss franc. The US dollar has of course gained too, with its trade weighted exchange rate rising 1.5 since August 1 extending its gains over the last year to some 15. After the big FX moves of the last few weeks, the natural instinct is to assume that markets will relax again and some part of these moves will unwind. This may indeed occur in the short term but there are also good reasons for thinking that there are risks of further big currency moves over the coming months. China: Balance of payments US$bn Non-FDI capital flows (est.) Trade balance Services balance FDI Change in FX assets Source : Oxford Economics/Haver Analytics In particular, there looks to be a real danger that depreciation may extend further in China. Recent evidence on growth in China has been unpromising we estimate underlying GDP growth may be as low as 3- with policy measures to date having only a modest impact. Currency depreciation looks to be one of the better policy choices, if the authorities want to increase stimulus, especially as it arguably is less risky than the traditional credit/fiscal stimulus options in terms of reinforcing the structural distortions in the economy. Moreover, there is evidence that depreciation pressures, in the form of capital outflows, remain strong. We estimate non-fdi capital outflows at around US$79 billion in July but for August the number may be double that with outflows persisting and even intensifying after the August 11 depreciation. If the authorities continue to cut interest rates and/or boost liquidity through cuts in bank reserve requirements capital outflows may intensify and have to be accommodated with some more depreciation. Commodity exposure the key risk factor One way to assess China-related currency risks going forward is to build a simple scorecard of vulnerability indicators. We have done this for 1 emerging and advanced economies, based on three indicators: Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com

3 1 Sep 15 Emerging Markets The share of a country s exports going to China: a variable which aims to capture the potential impact of direct trade links with China. Net commodity (oil and non-oil) exports of a country as a of GDP: a variable that aims to capture the impact of China-related declines in commodity prices, a key transmission channel from a weaker China to the world economy given China s dominant position in many commodity markets. The current account deficit as a of GDP: a variable that aims to capture the potential risks to a country from an interruption of capital inflows related to a reduced global risk appetite. Current account deficits can also indicate weak domestic fundamentals or serious economic imbalances which might lead investors to take a dim view of a country. We rank our sample of countries by each indicator and then derive an overall risk rank based on a simple average of the indicators. The results indicate that the riskiest advanced currency is the Australian dollar. Australia is a large commodity exporter and remarkably now sends more than a third of its exports to China. Australia s current account is also in deficit to the tune of 3 of GDP. The UK and Canada meanwhile fall in the moderately risky zone; both have large current account deficits while Canada is a net commodity exporter. Among the emerging currencies, the riskiest are the currencies of,, South Africa,, Argentina and Malaysia. All are significant commodity exporters, several are strongly exposed to direct trade with China and all but Malaysia have deficits on the current account. At the other end of the scale, the least risky countries include the Eurozone,,,, and. All are net commodity importers (whose terms of trade should improve from falling commodity prices) and most have current account surpluses. The risk scores generated by this framework correlate quite well with actual currency performance since August 1; the simple correlation coefficient is about.5. There are some notable anomalies, however, which are worthy of attention. Among the riskiest countries, Argentina stands out as having seen only limited FX depreciation. This is surprising given the country s weak fundamentals and exposure to soybean prices which are China-sensitive. Argentina s currency is a managed one, however. It may well be the case simply that depreciation pressures are simply being stored up. The risk of a sharp correction in the currency looks to be high over the coming months, once the October elections are out of the way. Exports to China, Net commodity Current account, Overall risk Currency change vs. of total exports, of GDP of GDP rank US$ since Aug 1, Australia = = -. South Africa Argentina Malaysia Canada UK = -.1 US = 1.5 Russia Turkey Japan = = -.1 Philippines = = Eurozone = =. Notes: Exports to China in 1, commodity exports average 1-13, current account 15 OE forecast Overall risk rank based on simple average of ranks of each indicator US currency change is trade-weighted dollar Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 3

4 1 Sep 15 Emerging Markets...with trade links less important so far Another apparent anomaly is that many of the countries with large direct trade links to China have not seen strong depreciation. Indeed, there is essentially no statistical correlation between the share of exports to China and recent currency performance. World: China exports and FX performance FX performance vs. US$ since Aug 1, Japan Exports to US China as of Eurozone total Canada Argentina UK - Russia - Australia Turkey S.Africa - Malaysia -1 Source : Oxford Economics/Haver Analytics How can this pattern be explained? In the case of China s close Asian trading partners such as and we believe the relative resilience of their currencies reflects the fact that they are net commodity importers and also have large current account surpluses which protect their currencies from swings in global capital flows. On top of this, there is evidence that currency moves have been limited by central bank intervention especially in. Japan, like and, is a net commodity importer and runs a current account surplus. But on top of this, the yen has a tendency to gain in periods of global uncertainty as Japanese investors repatriate overseas assets (the result of course of years of accumulated current account surpluses). Like the yen, the US dollar has a reputation as a safe haven currency and this is borne out by recent developments: the dollar has gained despite the US looking moderately risky according to our scorecard. We believe the dollar s safe haven status reflects the special nature of US financial markets, whose size and depth and denomination in the global reserve currency gives them an irresistible draw in times of global uncertainty. We would note though that despite this, the dollar has gained less than the euro or yen. One reason for this is likely to be a compression of the interest rate differential between the dollar and these currencies expectations of US rate hikes over the next 1- years have been pared back since early August while no such expectations existed in the Eurozone and Japan. Several EMs have done worse in terms of currency performance than their risk scores might suggest. Russia is one of these: its risk score is boosted by its current account position but this probably flatters the country. Russia also has a massive problem of structural capital flight and remains cut off from international markets by sanctions. Another is Turkey which has low exposure to Chinese trade and is a net commodity importer. But Turkey s fundamentals are very poor (including a large current account deficit) and with political risk also elevated this probably explains its weak currency performance. World: Currencies and China risk ranks change in currency versus US$ since Aug 1* Australia South Africa Argentina Malaysia Canada UK US Russia Turkey Japan Philippines Eurozone Riskiest countries Countries arranged top to bottom in order of decreasing China-related risk Least risky countries Source : Oxford Economics/Haver Analytics * for US, trade-weighted FX Less easy to explain are the large currency declines in and relative to their risk scores. In s case it may be that the changed international environment is leading investors to take a more sceptical view of growth prospects than was recently the case, perhaps focusing on the recent slowdown in reforms. may be suffering from being a relatively liquid and easy accessible market, with the currency being sold off as a proxy hedge for less liquid/open emerging markets. Model simulations also suggest some anomalies Another approach to identifying potential risks from the China devaluation across countries is to use the Oxford Economics Global Economic Model (GEM). As the model is a fully integrated global system where countries are Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com

5 Philippines Turkey USA Argentina Eurozone Canada Australia UK Malaysia S.Africa Russia Japan 1 Sep 15 Emerging Markets linked through foreign trade, exchange rate and commodity price movements it may capture some more complex international interactions than our scorecard. For example, a country may not trade much with China but its exports may compete with those of China in third markets and so may still lose out from China s devaluation. Alternatively, a country may not trade much with China but may trade a great deal with countries that do, and so will be hit if that country s GDP slumps due to China-related effects. Using the OE model we have examined in recent analyses the impact of a sharp economic slowdown in China across a range of countries, and the results of these simulations can be used as an alternative risk indicator for currencies. World: China downside effects and currencies China downside scenario effect on GDP by 17 Currency change v. US$ since Aug 1 Conclusion China s surprise devaluation has set off a chain reaction of large currency moves across the rest of the world, and there could well be more to come. There are compelling reasons for expecting further depreciation in China, not least of which is that China s effective exchange rate is still over 1 above the level of a year ago even after the devaluation. China is very much the odd one out among the major emerging markets in this regard: in a period where emerging currencies have on the whole done very badly, China s currency has been gaining implying a broad-based loss of competitiveness against other EMs. World: Effective exchange rates change in nominal effective exchange rate since August 1 1 US Argentina China Switzerland Philippines UK Eurozone Japan South Africa Canada Turkey Australia Malaysia Ukraine Russia Source : Oxford Economics/JPM Morgan/Haver Analytics Source : Oxford Economics/Haver Analytics If we look at the estimated impact on GDP by 17 of our current China downside model scenario, we can see that there is a loose relationship with currency moves since August 1: most of the countries with bigger depreciations are those that the model scenario suggests would be hard hit in GDP terms by weak Chinese growth, while countries with lower estimated GDP impacts from a slower China have mostly seen smaller FX moves. But as with the scorecard rankings, there are again significant anomalies. Two of the countries with the biggest negative impacts on GDP according to our model scenario, and, have seen quite modest depreciation while Japan also hit hard in the model scenario has seen its currency gain since August 1. Turkey, meanwhile, has seen one of the biggest currency depreciations but is not badly hit in the model scenario. Our simple scorecard framework for assessing FX vulnerability to China-related pressures finds that the commodity-sensitive EMs and Australia are among the most at risk. Some of China s close trading partners like and have meanwhile not suffered much yet. This is probably partly due thanks to large current account surpluses, but also reflects currency intervention. Bigger currency moves in these Asian countries may yet be in the pipeline, and weak Chinese growth may also manifest itself there in other ways e.g.by increasing deflation pressures and compressing interest rates. This article was first published on September. For further information contact Adam Slater (aslater@oxfordeconomics.com) Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 5

6 1 Sep 15 Emerging Markets Latest data Recent Data Releases Previous month Latest Comment China CPI (Aug) Manuf. producer prices (Aug) Exports (Aug) Imports (Aug) Trade balance (Aug,m total) 1. y/y -.5 y/y -. y/y -. y/y $53.bn. y/y -.9 y/y -5.5 y/y -13. y/y $5.bn Dull trend in exports continues which is likely to spur the authorities to consider further depreciation of the CNY. Meanwhile, imports are depressed because of very low commodity prices, subdued business and consumer confidence, and investment slowdown. Russia GDP (Q, s. adj.) Consumer prices (Aug) -1. q/q -. y/y 15. y/y -. q/q -.5 y/y 15. y/y Deep recession driven by plunge in domestic demand in response to jump in inflation, sanctions, more difficult financing conditions and lower confidence levels. Inflation is running at a higher level in Q3 than we had been expecting, and the RUB s fall in August will push up import prices again. Employment (Aug) Unemployment rate (Aug, s.adj) 1. y/y y/y 3. Labour market still in reasonable shape, with employment rising and wage growth of 3-. Consumer prices (Aug) Consumer confidence (Aug).7 y/y 91.. y/y 9.9 Despite peso decline, inflation is still below 3 target. But consumer confidence now ebbing. Turkey Retail sales vol. (Jul) Industrial output (Jul) Current account (Jul,m total) GDP (Q, seas.adj.) Consumer spending (Q) Investment (Q) Export volumes (Q) 3.9 y/y. y/y -$.3bn 1.5 q/q. y/y.5 y/y.3 y/y -. y/y. y/y.7 y/y -$5.bn 1.3 q/q. y/y 5.1 y/y 1. y/y -1.7 y/y Quarterly GDP growth was quite a bit stronger than we had expected, with a surge in investment the main factor (probably financed by heavy borrowing). However, this is unlikely to persist given the rise in political uncertainty, a subdued external background and increasingly difficult financing conditions. Despite the plunge in oil prices this year, the current account gap is still running at a substantial US$5bn a year. Exports (Aug, US$) Imports (Aug) Trade balance (Aug,m total) Consumer prices (Aug) y/y -17. y/y $5.bn -. y/y -1. y/y -1.7 y/y $5.1bn -. y/y Weak performance of exports has carried over into Q3, which is worrying for the overall growth outlook. Indeed, sales to US are now down on a year ago, as are exports to other key markets (largest fall is to ASEAN). IMACEC activity index (s.adj, Jul) Consumer prices (Aug) Core CPI (Aug). m/m 3. y/y. y/y.9 y/y.1 m/m.7 y/y 5. y/y.9 y/y Growth still quite patchy, with consumer spending growth threatened by renewed rising trend in CPI inflation (in large part the result of the depreciating peso and stubbornly high growth in unit labour costs). Malaysia Exports (Jul, US$) Imports (Jul) Trade balance (Jul,m total) -9. y/y -15. y/y $3.bn -13. y/y -11. y/y $.5bn External surpluses are not big enough (reflecting low commodity prices and relatively buoyant domestic demand) to counter the impact of capital outflows on the MYR. Czech Ind. output (Jul, s. adj) 1. m/m.1 y/y 1.3 m/m 7. y/y Strong industrial performance reflecting solid domestic and external demand. Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com

7 1 Sep 15 Emerging Markets Asia China: Trade US$bn (seasonally adjusted) Exports 9 Imports China: Inflation 1 CPI - Non-food CPI - - Manufactured goods PPI Source: China Bureau of Statistics : Exports by destination US$bn (seasonally adjusted) 1 China & HK Rest of emerging Asia 1 1 Source: Ministry of Finance / Oxford Economics US Europe East Asia: Exports (3 month moving average) 5 China Emerging Asia: Short-term interest rates 7 China 5 3 Malaysia ASEAN: Goods' Exports (US$) Malaysia -3-3 month moving average Philippines Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 7

8 1 Sep 15 Emerging Markets Asia Emergers: Equity markets Index (Dec 3, 1 = 1) China Jan 11 Jan Jan 13 Jan 1 Jan 15 Hong Kong: Asset prices H1 = Housing Offices 9 Stockmarket Source: Hang Seng Index Services / Hong Kong Rating & Valuation Dept. Emergers: Exchange rates v US$ Index (Dec 3, 1 = 1) China appreciation Jan 11 Jan Jan 13 Jan 1 Jan 15 Emergers: Exchange rates v US$ Index (Dec 3, 1 = 1) 11 appreciation Philippines 15 Singapore Malaysia 75 7 Jan 11 Jan Jan 13 Jan 1 Jan 15 : Nikkei Manufacturing PMI 5 = expansion/contraction breakeven point : Interest rates 3-month interbank rate year government bond yield Repo policy rate Source: Markit Jan 11 Jan Jan 13 Jan 1 Jan 15 Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com

9 1 Sep 15 Emerging Markets Latin America Latin America: Consumer prices 1 Mexican GDP & US non-oil import volumes Colombia 9 US non-oil import volumes (RHS) Mexican monthly GDP proxy (LHS) Latin America: Imports of goods Index (seasonally adjusted, 13=1) 11 Argentina : Monthly indicator of economic activity =1 (IMACEC, seasonally adjusted) Latin America: Short-term interest rates Emergers: Exchange rates v US$ Index (Dec 3,1 = 1) Colombia 7 Argentina depreciation Jan 11 Jan Jan 13 Jan 1 Jan 15 Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 9

10 1 Sep 15 Emerging Markets Emerging Europe Central Europe: Industrial output Index (H1 = 1) Czech Hungary 7 Slovak Central Europe: Merchandise exports in EUR 1=1 (seasonally adjusted) Slovak 1 Hungary 9 7 Czech Central & Eastern Europe: Consumer prices 1 1 Russia 1 1 Hungary Czech Russia and : GDP 15 9 Russia Russia: RUB and oil price Oil price (US$ pb) RUB per US$ (inverted) Russia: Interest rates Interbank rate (31 to 9 days) RUB per US$ (RHS) 7 5 Oil price (LHS) Jun 1 Aug 1 Oct 1 Dec 1 Mar 15 May 15 Jul year bond yield 9 1-week repo rate 3 Jan 11 Jan Jan 13 Jan 1 Jan 15 Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 1

11 1 Sep 15 Emerging Markets Rest of World Turkey: Real GDP GDP Consumer spending Investment Exports Turkey: Interest rates and inflation Average bank lending rate 1-week interbank rate "Core" inflation / Oxford Economics South Africa: PMI 5 = expansion / contraction line 5 Emergers: Exchange rates Index (Dec 3, 1 = 1) Turkey (v Euro) 5 7 S. Africa (v US$) depreciation Jan 11 Jan Jan 13 Jan 1 Jan 15 Malaysia: Foreign exchange reserves US$ bn 1 Emergers: 1 year government bond yields Turkey South Africa Source : Oxford Economics/Bank Negara Jan 11 Jan Jan 13 Jan 1 Jan 15 Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 11

12 1 Sep 15 Emerging Markets Industrial Production Percentage changes on a year earlier unless otherwise stated China Russia Turkey 1 Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Consumer prices Percentage changes on a year earlier unless otherwise stated China Russia Turkey 1 Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com

13 1 Sep 15 Emerging Markets Exports (US dollars) Percentage changes on a year earlier unless otherwise stated China Russia Turkey 1 Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Imports (US dollars) Percentage changes on a year earlier unless otherwise stated China Russia Turkey 1 Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Economist: Simon Knapp, Senior Economist Tel: sknapp@oxfordeconomics.com 13

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