Floor getting lower for Chinese yuan

February 2, 2016

RTX23HPP.jpgWhen predicting the Chinese yuan, some forecasters seem to be coming around to the idea that calling an immediate floor on the currency may be a difficult call to make.

At least that’s the message from Societe Generale, which on Monday put a one-in-three probability of the Chinese yuan sliding to 7.50 by the end of 2016.

For perspective, that would mark the lowest level since October 2007 — when the financial crisis had still to take hold and when the world was busy egging China to allow its currency to rise in proportion to economic growth.

For a long time China has kept its currency on a tight leash, allowing it to rise or fall in a manner that benefited the country.

But as the economy grew in size to become the world’s second largest and trade between China and the rest of the world multiplied, the uncertainty around the yuan, and difficulty in predicting its moves, has rattled financial markets from Asia, to Europe to the United States. The Shanghai Composite Index alone fell over 10 percent last month.

Managing market expectations and communicating its policy has also turned into a headache for Beijing with policymakers’ statements sometimes conflicting with actual mid-point settings in the yuan.

Strategists at Societe Generale wrote in a report titled ‘Strategies for a CNY7.5 world':

The People’s Bank of China (PBoC) may insist that it has no intention to devalue the yuan, but capital flows are putting significant downward pressure on the currency. China’s FX reserves are large but far from unlimited, or even sufficient if large capital outflows persist.

Our central scenario (65 percent probability) envisions USD/CNY reaching 6.80 in 2016 in a largely gradual and controlled manner, but there is a large and growing risk (35 percent) that USD/CNY trades up to 7.50 this year.

Many, at least among those outside of China, say Beijing has only itself to blame for much of the recent capital flight.

The two sharp yuan devaluations since last August, aimed at protecting China’s exporters, have roiled markets and investors have fled to relatively safer assets, worried that the world’s second largest economy was slowing much more than expected.

The yuan was devalued 2 percent in August and then again by 0.5 percent early January, both considered steep cuts among otherwise minuscule daily moves, raising fears central banks elsewhere would also devalue their currencies to remain competitive against cheap Chinese exports.

 

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The result was widespread mayhem in financial markets with global stocks, currencies and commodities tanking.

And despite repeated assurances from policymakers, even as high as Premier Le Keqiang, that China has no intentions to weaken the yuan on a sustained basis — no one’s really sure.

A Reuters poll last month showed the yuan would trade at 6.70 a dollar by the end of December, the weakest consensus for the exchange rate since at least January 2013 – when Reuters began polling on the currency on a periodic basis.

That’s just about 2 percent lower than the current rate of 6.57 and could be an indication of how seriously forecasters have taken Beijing’s no-further-devaluation rhetoric.

Only Rabobank, from the sample of over 50 banks and research institutions, had a base-line scenario of the yuan reaching as low as 7.60 by year-end. On the other hand, just 10 predicted the yuan would be higher than current levels by December.

Still, Societe Generale estimates China’s FX reserves have already fallen by $663 billion from mid-2014 and if outflows maintain their current pace — about $657 billion in the same period — the PBoC would be unable to defend the yuan for more than two to three quarters.

 

Societe Generale strategists added:

China concerns sit at the heart of one of the most dramatic starts to a trading year on record. Looking ahead, we believe that further CNY weakness is on the cards, with China managing the pace via a combination of currency intervention (drawing down reserves) and tightening of capital controls.

The fear is, however, that China may not enjoy sufficient control over this process, with the risk of greater capital flight and a sharper drop in the yuan.

Sure, the move to USD/CNY 7.50 is still an outside case for Societe Generale and perhaps for most market watchers. But this isn’t the first time analysts have predicted such sharp moves in currencies.

About a year back, Deutsche Bank and Goldman Sachs and others incorrectly called for the euro to breach parity against the dollar sometime in 2015. The lowest it dipped to was about five cents above one dollar.

Still, the fact forecasters have started contemplating such weakness in the yuan shows how much more likely it has become all of a sudden.

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