MARKET INSIGHTS
Market Bulletin
16 August 2016
Chinese yuan: Walking on a tight rope
In brief
Tai Hui
Chief Market Strategist for Asia
Ian Hui
Global Market Strategist
•
Recent trends suggest the Chinese authorities are allowing the Chinese yuan to
depreciate against a basket of currencies in an orderly manner. We expect this
trend to continue in the medium term, given the yuan’s relatively high valuation on
a trade-weighted basis.
•
Although this implies future episodes of the yuan weakening against the U.S. dollar,
the speed and magnitude of the depreciation will likely be capped by the dollar’s
own weakness and by Beijing’s desire to want to avoid triggering local investor
panic.
•
In our view, the Chinese authorities have policy tools sufficient to avoid a currency
collapse. We anticipate an orderly depreciation, which poses less of a threat to the
global financial landscape than some media headlines have suggested.
•
As in other emerging markets, managing currency risk is a necessity. Yuan-based
investors should consider diversifying into international assets to manage their
currency exposure. Global investors should manage yuan exposures as well, in
order to tap into China’s long-term structural growth and income opportunities in
its equities and fixed income markets.
Investors have been worried this year over the potential for Chinese yuan depreciation,
due to its negative impact on global financial stability and role in exporting deflation
globally. Alarming media headlines predicting the rapid, disorderly depreciation of the
yuan have been replaced by news about Brexit, the U.S. presidential elections and
other geopolitical developments; nonetheless, economic data continues to suggest the
potential for further yuan depreciation. Here, we address the forces, current and
historical, most likely to drive the currency’s moves. We believe they point to an orderly
depreciation that would be less of a threat to the global financial landscape than
headlines suggest.
We see the downward bias of the yuan on a trade-weighted basis as Beijing’s primary
objective. The yuan’s rich valuation, relative to its own history, and the prospects of
more capital account liberalization in coming years will make China’s defense of its
currency more difficult and costly. We view allowing the currency to adjust toward a
more reasonable valuation is a sensible strategy.
MARKET BULLETIN | AUGUST 16, 2016
Overvalued or undervalued?
Exhibit 1 shows that since 2005, when China ended its defacto currency peg to the dollar, the yuan’s real effective
exchange rate (REER) has risen by 40%, largely via the yuan’s
appreciation against the dollar. The yuan’s strength has
dampened China’s export performance in recent years,
especially when combined with weak global demand.
However, it has allowed Chinese consumers and investors to
benefit from cheaper imports of goods and services, and to
take advantage of international investment opportunities.
China’s current account surplus has declined in recent years
EXHIBIT 2: CHINA’S CURRENT ACCOUNT BALANCE
SHARE OF NOMINAL GDP, 4-QUARTER MOVING AVERAGE
12%
10%
8%
6%
4%
2%
0%
'99
The yuan has strengthened against the dollar since 2005
EXHIBIT 1: USD AND CNY REAL EFFECTIVE EXCHANGE RATE (REER)
INDEX, REBASED 31/12/2004 = 100
160
'03
'05
'07
'09
'11
'13
Early 2014 marked the end of the one-way appreciation of the
yuan against the dollar, reflecting the economic pain from a
stronger dollar and domestic slowdown. Since then China has
had five significant episodes of yuan depreciation, including
the one-off 3% devaluation on 11 August, 2015 (Exhibit 3),
unnerving markets and helping fuel fears that similar episodes
might follow.
CNY REER
120
USD REER
80
60
'05
'06
'07
'08
'09
'10
'11
'12
'13
'14
'15
'16
Yuan depreciation against the dollar in recent years
EXHIBIT 3: USD—CNY EXCHANGE RATE
USD—CNY
6.8
Source: FactSet, J.P. Morgan Asset Management. Data reflect most recently
available as of 8/8/2016.
6.6
Although Exhibit 1 shows that the yuan is expensive relative
to its own 10-year history, whether it is fairly valued remains
hotly debated. The International Monetary Fund (IMF) believes
that it is; upon completing a review of the economy in June, it
stated: “the renminbi (CNY) is assessed as broadly in line with
fundamentals, similar to our assessment in last year’s Article 4
consultation”1. A further indication that a high-speed,
disorderly CNY depreciation is unlikely can be seen in Exhibit
2. China’s current account surplus has declined from its peak
of more than 10% of GDP before the global financial crisis to
2%-3% in the past two years. The accumulation of China’s
foreign exchange reserve has also started to reverse over the
past 2.5 years (Exhibit 5), which adds to the argument that
the currency is close to fairly valued based on external
positions.
Staff Completes 2016 Article IV Mission To China,” International
Monetary Fund, Press Release No. 16/277, June 14, 2016.
1“IMF
https://www.imf.org/en/News/Articles/2015/09/14/01/49/pr16277.
2
C HI N E S E Y U A N : W A L KI N G O N A TI G HT R O P E
'15
Source: CEIC, J.P. Morgan Asset Management. Data reflect most recently available
as of 30/6/2016.
140
100
'01
11 August 2015:
One-off 3%
devaluation
6.4
6.2
6
5.8
'12
'13
'14
'15
'16
Source: FactSet, J.P. Morgan Asset Management. Data reflect most recently
available as of 8/8/16.
MARKET BULLETIN | AUGUST 16, 2016
Focusing on the currency basket
In December 2015, the China Foreign Exchange Trade System
(CFETS) introduced a new exchange rate valuing the yuan
against a trade-weighted basket of 13 currencies. One of the
purposes was to reinforce with the market that the yuan is no
longer tagged to only the dollar, but to a broader range of
currencies.
Since its introduction, the yuan has steadily declined relative
to this trade-weighted basket (Exhibit 4). We believe this 7.5%
depreciation is a deliberate move to improve the
competitiveness of the yuan and relieve pressure on the
economy.
Yuan depreciation against a trade-weighted basket of currencies
EXHIBIT 4: CFETS RMB INDEX
INDEX
105
102
99
96
93
90
12/15 01/16 02/16 03/16 04/16 05/16 06/16 07/16 08/16
Source: FactSet, J.P. Morgan Asset Management. Data reflect most recently
available as of 8/8/2016.
This dollar—yuan relationship is particularly important if, as
the market expects, the Federal Reserve is approaching policy
normalization with great caution. The implication is that a
smaller depreciation of the yuan relative to the dollar will be
needed to achieve Beijing’s objectives.
The imperative to stem currency outflows
Further supporting the case for an orderly depreciation is the
Chinese authorities’ awareness that al rapid devaluation of the
yuan could trigger further capital outflows. China needs to be
mindful of the impact excessive yuan weakening versus the
dollar has on investor confidence. Domestic investor
sentiment was shaken in late 2015 and early 2016 following
successive currency devaluation versus the greenback. This
led to increase capital outflows and a sharp fall in China’s
foreign exchange reserves (Exhibit 5). In the second half of
2015, China’s foreign exchange reserves fell by an average of
USD 61 billion per month. While this was partly due to
currency valuation adjustments, the majority of the decline
was due to outflows from the capital and financial accounts.
Confidence was restored, to some extent, between January
and April as the yuan rose modestly, and the decline in
reserves slowly — an average of USD 2.5 billion per month
between April and July 2016 — even as the yuan continued to
depreciate against the CFETS basket.
Stabilization in capital outflow and foreign exchange reserves
EXHIBIT 5: MONTHLY CHANGE IN CHINA’S FOREIGN EXCHANGE RESERVES
USD, BILLIONS
125
Since we can assume that Beijing’s objective is to continue
with this trend, the outlook for the broad dollar is an
important determinant of medium-term USD—CNY exchange
rates. If the multi-year dollar bull market is approaching its
end, then the yuan could leverage the dollar weakness to
achieve a depreciation against its trading partners. For
example, when the USD REER weakened between January and
April 2016, the yuan actually appreciated against the dollar by
2%. Hence, China achieved its aim of weakening its currency
against a basket of currencies by riding the weaker dollar, but
without weakening against the dollar.
75
25
-25
-75
-125
'05
'06
'07
'08
'09
'10
'11
'12
'13
'14
'15
'16
Source: FactSet, J.P. Morgan Asset Management. Data reflect most recently
available as of 31/7/2016.
J.P. MORGAN ASSET MANAGEMENT
3
MARKET BULLETIN | AUGUST 16, 2016
INVESTMENT IMPLICATIONS
Chinese authorities possess sufficient policy tools to avoid a
currency collapse, but valuation and economic adjustments
imply that the yuan is likely to depreciate further, on a tradeweighted basis over the medium term. This should also lead to
episodes of weakening against the dollar.
We also note some short-term factors to consider. The Chinese
authorities are likely to maintain broad yuan stability, both
against the dollar and on a trade-weighted basis, ahead of key
events such as the G20 Summit in Hangzhou in early
September and the inclusion of yuan into the IMF’s Special
Drawing Rights in October. We saw a glimpse of such window
dressing during the G20 finance ministers and central bank
governors meeting in Chengdu in July.
Yuan-based investors should consider currency exposure in
their cash flows and balance sheets and take appropriate
action to mitigate currency risks by diversifying into
international assets. For international investors, we believe
that with appropriate currency hedging solutions, both the
Chinese equities and fixed income markets offer means to tap
into China’s new economy as well as income opportunities.
This is particularly important as China’s capital markets are
expected to become better represented in various important
benchmark indices in coming years, opening them up to many
more global investors.
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C HI N E S E Y U A N : W A L KI N G O N A TI G HT R O P E
MARKET INSIGHTS
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