The year of the Chinese yuan

The Chinese New Year, which kicks off on 8 February, is around the corner. Astrologically, it’s the year of the monkey. As far as the markets are concerned, though, it may as well be the year of the Chinese yuan.

The first full trading week of the calendar year certainly seems to point to that. The Chinese equity market has been halted for trade twice already this week due to a sharp fall in the indices. The trading halt on Monday was driven by a few factors, including the weak Chinese Purchasing Managers’ Index (PMI), but the resumption of the depreciation in the yuan was an underlying fear. On Thursday, when the Yuan was pegged lower by half a per cent, the Chinese equity market was once again frozen at the lower circuit of 7%.

To understand why the market is in panic mode, let us rewind to last year.

In August 2015, when China first devalued the yuan and subsequently signalled a more market driven exchange rate, the key questions being asked were: how quickly and how far will China let the yuan weaken? Are we looking at a 5% devaluation or something more significant? As things stand, the devaluation has already moved beyond the 5% mark.

After an initial devaluation from 6.2 levels against the dollar, the yuan settled at close to the 6.4 mark, and then remained around there till about December. However, over the past one month, the depreciation has resumed and the Chinese currency has moved down to near 6.6 levels.

Since the end of July 2015, the onshore yuan has already fallen by 6%. The offshore yuan has fallen by a steeper 7.5% and is now at its lowest level seen in more than five years. The spread between the onshore and offshore yuan has also been widening, which the markets are seeing as an indicator of more weakness to come in the official currency rate. This belief stems from the Chinese government’s intention to allow the currency fix to be more market determined, which allowed it an entry into the elite Special Drawing Rights (SDR) basket of the International Monetary Fund (IMF).

To be sure, few believe that China will allow market forces to move the currency to levels beyond what it is comfortable with. On 30 December, Reuters reported that China had moved to suspend the foreign exchange operations of some foreign banks. The move was seen as part of an effort to stem excessive speculation in the market, Reuters had reported. Still, the markets aren’t ruling out further depreciation in the Yuan this year. In a note on 6 January, HSBC Global Research wrote that the markets should be prepared for the risk of further depreciation in the Chinese currency in the near term.

“...seasonal factors such as corporates’ front-loading FX (forex) hedging and the reset in Chinese individuals’ $50,000 annual FX conversion quota, could lead to increased USD (US dollar) demand at the beginning of 2016. Growth and credit risk headlines could also add to the headwinds for the currency...,” said HSBC analysts, adding that pressure on the currency may abate after the second half of 2016.

Whether this pressure means that the depreciation in the yuan will move closer to 10% levels or more is the moot point. With China’s forex reserves falling by a massive $108 billion in December, China’s ability to stem the fall in the Yuan, while still substantial, may stand reduced. Some are of the view that the impact of the yuan depreciation on global asset markets may be more muted this time around compared to what was seen in August last year.

Deutsche Bank analysts took this particular view in a report earlier this week and said that the “beta” of global currencies to weakness in the Chinese currency will be lower now than in August 2015. The “novelty” of a weaker yuan is wearing off, they said. That may be true. After all, market reaction to known unknowns tends to be more manageable. That logic, however, will not hold true if the global markets believe that this is the long-feared hard landing in China. The view on that is divided.

Veteran investor, George Soros, told Bloomberg News that the adjustment in China amounts to a crisis. Stephen Roach, formerly of Morgan Stanley, took a different view and told Bloomberg TV that the “hard landing school” was wrong.

All India can do is manage the situation. The domestic equity markets will undoubtedly respond to global volatility in the short term. There is no getting away from that no matter how hard we pitch our relatively better fundamentals to the global investor community. In the long term, we may stand to benefit if fund flows are redirected our way. The rupee markets, too, will directionally follow the yuan like all other Asian currencies. The rupee has adjusted each time there has been a meaningful move in the yuan, although the quantum of depreciation differs. Since end-July, the rupee has fallen nearly 4%, compared with the 5.27% drop in the yuan. The Reserve Bank of India has smoothed over any jerky moves and that will continue.

The upside is that turmoil in China may mean that commodity prices remain in check for longer. Lower commodities have been key to the fiscal consolidation we have seen this year. It has also been important in keeping inflation pressures in check and has allowed for an expansion in operating margins for companies. We could do with that help for another year.

Ira Dugal is assistant managing editor, Mint.