22 May 2019
It is unlikely that Beijing will step in again soon to safeguard the renminbi after its inclusion in the SDR basket. Photo: Bloomberg
It is unlikely that Beijing will step in again soon to safeguard the renminbi after its inclusion in the SDR basket. Photo: Bloomberg

Yuan devaluation is a double-edged sword

The debut of China’s circuit breaker mechanism accelerated the market selloff on the first trading day of the year.

Many factors contributed to Monday’s slump. The offshore renminbi weakened to 6.6135 against the US dollar. Investors also worried a registration-based system for initial public offerings will start soon. The ban on share sales by major stakeholders of listed companies will also expire on Jan. 8.

Of these, the Chinese currency will be the most critical factor affecting equity markets in mainland China and Hong Kong – and even worldwide.

The recent slump in A shares partially stems from mounting expectations of a yuan depreciation.

Market forces have been granted greater power after the daily fixing reform last August. The spread between onshore and offshore market has widened to 1,138 basis points on Sept. 7 after a one-off devaluation of 2 percent.

Beijing has actively intervened in safeguarding the renminbi before its inclusion in the International Monetary Fund’s Special Drawing Rights basket.

As a result, the renminbi has strengthened to between 6.51 and 6.32 against the US dollar.

However, Beijing has taken its hands off after the SDR inclusion, which was followed by a deep decline of the currency.

Market participants might get disappointed as it is not likely that Beijing would step in again.

First, China may need to pay a hefty price for its market intervention given the continued massive capital outflow.

Second, the dollar is poised to stay strong as a result of the rate hike cycle.

Third, Beijing is expected to further ease the monetary policy to stimulate economic growth.

The offshore renminbi once tumbled below 6.65 against the dollar on Tuesday, and the spread between onshore market widened to 1,300 basis points, the highest on record.

The Chinese yuan is set to weaken further as it has been overvalued in previous years. It may need to tumble to 7 to 7.4 against the dollar if China decides to end the vicious cycle of capital outflow and currency depreciation.

Kyle Bass, the famous hedge fund manager who made a big fortune betting against subprime-mortgage securities in 2007, said recently: “Given our views on credit contraction in Asia, and in China in particular, let’s say they are going to go through a banking loss cycle like we went through during the Great Financial Crisis.

“The Chinese currency has effectively appreciated about 60 percent versus the rest of the world since 2005 and it’s killing them, and the banking system has expanded 400 percent in seven years without a non-performing loan cycle. My view is we are going to see a non-performing loan cycle,” he said, adding that China’s non-performing loans could reach US$3 trillion.

Therefore, he said, if the debt problem gets too severe, a country can only solve it by a devaluation (via the export channel), inflation (to make local currency debt worth less in real terms), writeoff/re-cap or default.

Bass stressed that there will be a pretty material devaluation in the next 12 to 18 months.

Nevertheless, a weaker yuan would benefit Chinese exporters. But it’s a double-edged sword. Currently, it remains unclear to what extent would currency devaluation boost exports given the subdued global economic growth.

Also, Hong Kong-listed Chinese companies would report foreign exchange losses on their balance sheet, and this would affect their bottom line.

Moreover, some of them may have invested in derivatives like target redemption forwards to bet on yuan’s appreciation, which would suffer a huge loss and create a domino impact.

It seems that a one-off deep devaluation is more feasible in a bid to stabilize the renminbi.

However, that is set to affect company earnings, or even trigger a hidden bomb in currency derivatives invested by Chinese companies.

This article appeared in the Hong Kong Economic Journal on Jan. 6.

Translation by Julie Zhu

[Chinese version 中文版]

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Department of Investment Analysis at HKEJ

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