by Craig Stephen at Marketwatch
The fault line in China’s struggling economy has just extended from its equity to its currency markets. With all eyes focused on Beijing’s epic, state-orchestrated stock-support program, the central bank on Tuesday surprised markets with an almost 2% devaluation of the yuan, the largest since 1994.
The People’s Bank of China (PBOC) was quick to say that dropping the central parity yuan exchange rate to 6.2298 was a one-off adjustment. But at the same time, it also acknowledged it was reacting to external pressures due to the yuan’s excessive appreciation in real terms, given the sharp depreciation in the euro and the yen.
Investors now need to assess whether China is ready to embark on a new yuan weakening cycle. While this may boost exports and give the economy a lift, it is also a potentially hazardous path as authorities juggle potential capital flight and corporates holding substantial foreign currency debt.
The economic pain from an overvalued currency has been evident for some time but until now Beijing has chosen to ignore it. That was primarily for policy reasons, ranging from deterring capital outflows and to help its case for inclusion as an International Monetary Fund reserve currency.
This first step is unlikely to be the last, analysts say.
But it looks as if the government’s pain threshold has been reached after last weekend’s dismal trade figures, which saw exports drop 8.3% in July from a year earlier. There is also worry that widespread industrial deflation is worsening after July factory prices fell at their lowest level in six years, down 5.4%. Meanwhile, as Chinese consumers spend big abroad with a strong yuan in their pockets, there is fresh signs of weakness at home, such as declining auto sales.
Taken together, this may have tipped authorities toward the view that there is more to gain from a change in currency policy. It would also mean the PBOC becomes the latest central bank to use currency depreciation as the last resort to rescue the economy.
This first step is unlikely to be the last, say analysts. According to calculations by BMI Research, the yuan has had a 16% effective appreciation in the past year, and that move would do little on its own to restore competitiveness. But they say it is still highly symbolic.
At the same time, any shift in exchange rate policy comes with considerable risks. Even if the PBOC proceeds with incremental moves this can end up being a red flag to speculators when you have previously operating a pegged currency regime. The risk is yuan weakness is seen as a one-way bet and can become self-fulfilling as more positions are added.
Beijing’s predicament comes from its attempts to square away the “Impossible Trinity.” But a government cannot have exchange-rate and interest-rate targets as well as free capital flows at the same time.
Read: What yuan move means for September Federal Reserve rate increase
Hence, attempts by authorities to boost growth through rate and reserve ratio cuts have been partially frustrated by capital leaving the country. Some analysts have calculated capital outflows have reached up to as much as $800 billion in the past year.
In recent weeks it would hardly be surprising if the panicky government actions to shore up the equity market had not contributed to further capital leakage. First, many investors would have been troubled by the substantial amount of stock suspensions, effectively trapping funds in illiquid stocks.
Further, moves by Beijing to use state entities to directly buy the equity market also is likely to trigger unease at the wider implications to financial stability.
In a new research note, Credit Suisse warns a set of abnormal bank lending numbers could be released this week as commercial bank lending to support the China Financial Securities Corp. — the organization charged with supporting equity markets — leads to a blowout lending number. If interbank lending is included, this could see stock lending for July reach 1.5 trillion yuan, with possibly up to 80% related directly to stock support.
Also see: These are the 20 China-exposed stocks to avoid
Such a scenario where stock support is flowing directly from the state banks is likely to sound an alarm. That will raise further questions about the sustainability of the scheme, as well as the transfer of risk to the banking system.
Meanwhile, if expectations do build of larger moves lower in the yuan, this will provide opportunistic investment opportunities. Expect Hong Kong, due to its proximity to China, to be a key beneficiary of money outflows. Equities with Hong Kong-based assets, as well as property, should also benefit, together with manufacturers with a cost base in yuan and foreign currency export revenue.
Conversely, potential casualties of a more dramatic yuan devaluation would be corporates with yuan revenues and foreign currency debt, such as mainland property developers, together with their foreign bond holders.