“Between A Rock And A Hard Place” – China’s Latest Yuan Gambit

So last week, we suggested that people might be thinking far too hard about stronger yuan fixings and the PBoC’s move to introduce what China is euphemistically calling a “counter cyclical adjustment factor” to the fixing mechanism.

The spot had begun to deviate materially and habitually from the fixings and analysts’ models were routinely predicting weaker fixes than what ultimately emanated from the PBoC. Plus, policy banks were selling dollars in the onshore market. Clearly, Beijing was getting concerned about capital flight. Here’s what we said:

Yes, “this is a pattern.” Or, put differently, this is the PBoC scrapping or at least temporarily sidelining the market’s role in determining how the onshore yuan trades. The last thing you want if you’re already destabilizing everything from the bond market to the stock market to commodities by squeezing your elephantine shadow banking complex, is for the currency to go into free fall again because then you’d have to add “accelerating capital flight” to the list of fires you’re trying to fight.

Well needless to say, the Moody’s downgrade didn’t help. So what did China do? They simply codified what they were doing anyway. They went public with the “counter cyclical adjustment” factor they were already applying.

The thing to remember (or maybe “renmember” is better) here is that a weaker currency could help the export-driven economy, but at this juncture, discouraging capital flight seems to be the overriding concern. As noted in the excerpted passage above, “the last thing you want if you’re already destabilizing everything from the bond market to the stock market to commodities by squeezing your elephantine shadow banking complex, is for the currency to go into free fall again because then you’d have to add “accelerating capital flight” to the list of fires you’re trying to fight.”

Well on Monday, Bloomberg’s Kyoungwha Kim is out saying precisely the same thing. Read below for more and do note the characterization of this situation as “between a rock and a hard place.” That’s just another way of saying “tightrope walk,” “spinning plates,” “juggling act,” etc. It’s always the same story – China wakes up every day and tries to do something that’s for all intents and purposes impossible.

Via Bloomberg

Stuck between a rock and a hard place, China is likely to strengthen the yuan in order to lure foreign capital as the liquidity lifeline to stabilize growth in the world’s second-largest economy.

  • Last week’s downgrade of China’s credit rating by Moody’s Investors Service highlights how the country’s leaders are caught in a quandary as they struggle to rein in leverage while maintaining the pace of economic growth. It’s getting increasingly difficult to rely on debt to fund the expansion and China’s deleveraging measures are starting to bite
  • For China to achieve 2017’s 6.5% growth target and keep the economy stable beyond then, it will need an external supply of liquidity. According to the quantity theory of money, a change in money supply is the main influence on price and output levels and a key driver of economic activity
  • The government’s efforts to open up the bond market, and link mainland stock markets with Hong Kong, haven’t yet attracted sizable inflows of foreign capital due to investors’ concerns over yuan depreciation
  • The catalyst for the PBOC to strengthen the yuan seems to have been Moody’s surprise downgrade on May 24. A subsequent abrupt surge in offshore-yuan funding costs, suspected to be on the PBOC’s intervention, has made it extremely expensive to hold short yuan positions
  • That was followed on May 26 by the PBOC’s plan to add a ‘counter-cyclical factor’ in the CNY fixing formula which it can apply in times of market stress. While this is viewed by some analysts as two steps back in moving toward a free float, it will certainly give the PBOC more leeway to stabilize the yuan
  • China is opening up in order to make its local asset markets more international. If the yuan can remain stable, China’s $16 trillion bond and stock markets could be a mouth-watering venue for global investors in the hunt for both bargains and extra yield — helping to fill the void left by China’s deleveraging drive
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