Investable Thinking® Blog

CNY Depreciation: Side FXPuay Yeong GohSenior Economist, Emerging Markets DebtAUGUST 14, 2015

China is taking the long view with its recent currency depreciation, and on that basis the move should eventually be positive

for everyone. But it still looks set to cause short-term pain for its competitors and suppliers in the rest of Asia.

China’s central bank (PBOC) surprised the market on Tuesday, August 11, by devaluing the USD/CNY fix by 1.9%, the largest single day depreciation since the 2005 USD/CNY

de-pegging. More importantly, it announced that the USD/CNY fix will be largely determined by the previous day's close and overnight moves of its trading partners’ currencies.

If this is fully implemented, it implies that the USD/CNY would become a floating exchange rate with a four percentage point-wide trading band.

Another Step to Full ConvertibilityWe see this as another step towards Chinese policy makers' goal of achieving full convertibility and internationalization of the Chinese Yuan (CNY) and eventual liberalization

of the capital account.

Three factors may have motivated this week’s change:

We don't see this as the start of a competitive devaluation of the CNY. Rather, we think it is more about the PBOC managing the pace of appreciation in the trade-weighted

CNY. We think the PBOC will aim to keep the CNY close to the trend appreciation against its trading partners (Figure 1). Even after the adjustment over the past few days, the

CNY is still stronger than it was a year ago.

Figure 1. The Devaluation Brings the CNY Back to Trend AppreciationChina Real Effective Exchange Rate

Source: Bloomberg; Neuberger Berman

The desire to narrow the gap between the USD/CNY fix and the market exchange rate following the IMF suggestions for the CNY’s inclusion in the basket of currencies that

backs Special Drawing Rights (SDR);

1

The desire to shift the exchange rate regime from a semi-USD peg to a currency basket;2

The desire to further ease financial conditions and help China’s export sector.3

In the near term, the sharp appreciation of the USD since mid-2014 means that we may see further depreciation of the CNY versus the USD over the coming weeks. In addition,

we are likely to see more fluctuation in the CNY exchange rate than in the past as market makers adjust their quotation and trading practice.

While the authorities want a more market-determined CNY, we believe the PBOC is still going to manage, and smooth, the adjustment of the CNY against the USD. Given that

the PBOC can utilize its large foreign exchange reserves of over $3.6 trillion and its influence over the state-owned banks, we think the PBOC will have no problem maintaining

the CNY on the path that it desires.

Eventually, fundamental drivers should see the CNY return to the trend appreciation against its trading partners. China is still running a large external surplus, with a current

account surplus likely just below 3% of GDP in 2015, and close to a 2% surplus in net Foreign Direct Investment (FDI) balance. Moreover, the recent drop in oil prices and

decline in other commodities would lend further support to the current account. While capital outflows have been fairly large over the past six quarters (around $230bn), China

still has that $3.6 trillion in reserves and, as it continues to grow at a faster rate than other countries, capital inflows should resume. A more market-determined CNY would aid

this. Internationalization of the CNY and inclusion in the SDR plus liberalization of the capital account should also lead to more capital inflows.

Who is Vulnerable?A cheaper CNY would help exporters and hurt importers. As most imports for domestic consumption are commodities, the recent decline in commodity prices would help to

offset the depreciation of the CNY. Average income is expected to rise 8-10% this year, and so a 3-4% decline in the CNY on a real effective basis would only partially erode

the purchasing power of the Chinese consumer.

China’s external debt rose by more than $600bn between 2009 and 2014, but that is less than the $1.4 trillion increase in foreign exchange reserves over the same period. As

most corporates are hedged on their external liabilities and external debt is in any case a small proportion of their overall debt, a gradual CNY depreciation should have limited

impact on overall debt-servicing ratios.

However, some sectors may come under pressure. In particular, many property developers raised a large proportion of their debt in foreign currencies, and most of these do not

hedge their FX positions. On the other hand, property companies have started to switch their funding to onshore markets and other channels such as crowd funding and REITs,

and this can help mitigate the rise in offshore funding costs. Furthermore, 2015-6 will only see a limited number of external debt maturities.

Implications for AsiaIn the near term, continued depreciation of the CNY would lead to pressure for other Asian currencies versus the USD. North Asian economies appear most exposed, together

with Malaysia and Thailand. These are the economies that rely on exports to meet Chinese domestic demand, as well as competing with China to export to other countries.

These Asian exporters might be tempted to cheapen their currencies to mitigate the negative impact of CNY depreciation, and as a result we are taking a more cautious near-

term view on the Korean won, the Malaysia Ringgit, the Thai Baht and Taiwan dollars.

Figure 2. We Believe the Currencies of these Countries are Most ExposedAsian economies ranked by exports to and potential competition with China

Source: OECD-WTO; UNCTAD; Neuberger Berman

Longer-term, the story should be significantly different. Eventually, as the CNY returns to trend appreciation and China transforms into a more balanced economy, with higher

levels of consumption, manufacturing exporters like Korea, Taiwan, and Singapore should be well-positioned to benefit. But the road to that destination will be bumpy, with its

fair share of potholes for investors to steer around.

Implications for the CNY

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