Don’t Panic About The Yuan. Yet

To read the headlines, you’d think the Chinese yuan had depreciated through record levels. Or that something unprecedented was afoot.

The Chinese currency is mired in a seven-month losing streak (figure below), and there’s quite a bit of “don’t panic” commentary circulating. That’s never good. More often than not, your level of concern should rise commensurate with the ubiquity of “don’t panic” messaging. “Don’t panic” can be a contrarian indicator.

At the risk of becoming a contrarian indicator myself, I’d venture it’s probably not time to panic. Or at least not yet. Recent developments with the yuan are wholly explainable by way of China’s deteriorating economic outlook and the policy divergence between the Fed and the PBoC. The former is hiking, aggressively, and the latter is easing, in dribs and drabs, but easing nevertheless.

The lockdown in Chengdu underscored Xi Jinping’s commitment to “COVID zero,” and that means the Party’s growth ambitions for 2022 are now out of reach, something Beijing appeared to make peace with recently. With the exception of exports, the data is uniformly soft, and lockdowns won’t help. “COVID concerns will likely limit activity and domestic tourism, restricting any rebound in retail sales,” TD’s head of emerging markets strategy, Mitul Kotecha, said.

When it comes to China’s daily efforts to manage the currency’s slide, we’ve seen this movie before. Tuesday marked the tenth consecutive stronger-than-expected fix (figure on the left, below). It also marked the first above 6.90 in two years (figure on the right).

There’s obviously some tension there, but the string of strong fixes (relative to expectations) isn’t indicative of an irritable PBoC keen to chop off any hands (figuratively or literally).

Neither was there anything particularly remarkable about Monday’s FX reserve cut (a tweak aimed at arresting the pace of yuan depreciation), other than perhaps the size of it. The two percentage point move was double April’s reduction, which came amid lockdowns, a very rapid yuan slide and rumblings about a currency war in Asia.

“While the PBoC is evidently trying to restrain exchange rate volatility, there is no serious attempt to cap the upside when the US dollar is advancing on a broad front,” RBC’s Alvin Tan said, calling the move in the onshore rate “very orderly.”

Chinese officials despise a one-way bet. On anything, really, but especially on the currency. That’s all this is. Options now reflect less in the way of zeal to bet against the yuan. “In that light, I think the decline has been very well managed,” Tan remarked.

There’s probably some consternation about a potential breach of what casual commentators habitually refer to as the “psychologically important” 7-handle, but the taboo factor was diminished in August of 2019, when the PBoC let the yuan slide through that threshold following Donald Trump’s trade escalations. The figure (below) gives you some context for recent weekly moves in the offshore yuan. The grey-shaded area denotes the recent bout of depreciation.

Note that the depreciation pressure in April, when the PBoC last implemented a tweak like Monday’s, was much more acute (red dot in the figure).

At a time when exports are one of the only things still going right for the Chinese economy, a weaker currency is desirable, especially considering the likelihood that recessions in the developed world will crimp demand going forward. Inflation is low domestically, and China logged another record trade surplus in July.

That’s not to say things are going swimmingly. There are problems aplenty, and not just the sort that make for flashy headlines. “We think China’s broad basic balance position (sum of current account + direct investment + portfolio flows) will also weaken further in the months ahead, reducing underlying support for the CNY,” TD’s Kotecha went on to say, adding that although “firm net exports and an absence of outbound tourism have helped to maintain a healthy current account position, a likely moderation in exports going forward, together with weaker direct investment inflows and ongoing portfolio outflows, suggest a weaker external balance in the months ahead.”

That said, China learned a lot from 2015, when authorities botched an overnight devaluation, leading to capital flight. Many of the avenues for capital to leave the country illegally are now closed, something TD underscored.

In any event, the key is the pace of depreciation, not any specific level. That’s what the PBoC is attempting to manage. So far, anyway, their efforts don’t suggest anything approaching the sort of consternation that’s historically presaged aggressive pushback or heavy-handed intervention. As RBC put it, “there is absolutely no panic in the market.”

There may, however, be a sense of panic among countries who compete with China for exports. They could be forced to weaken their own currencies or risk losing out. That’d make for an interesting EM-DM divergence: Developed markets are engaged in a kind of “reverse” currency war, as advanced economies struggle to avoid importing (more) inflation. If China continues to countenance yuan depreciation, other emerging markets may be compelled to act accordingly, which could be perilous in the context of an ever stronger dollar and a resolute Fed that’s far more concerned about domestic inflation that capital outflows in the developing world.


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