China could face systemic risk as yuan weakens

January 16, 2016 08:03
If the renminbi weakens too much, it could cause panic selling in China's equity and property markets. Photo: Bloomberg

China's currency, the renminbi, went into a deep dive last week, with the unit hitting a near five-year low against the US dollar on January 7 in onshore trade.

At the same time, the stock markets also witnessed fresh turmoil after authorities introduced a circuit-breaker system to prevent excessive price swings in equities. 

With the circuit-breakers blamed for adding to the market volatility, rather than curbing it, the securities regulator announced that it was abandoning the new mechanism.

The news helped A-shares rebound on Jan. 8, but the relief was only temporary.

Given the uncertainties surrounding the Chinese economy and its currency, financial markets in the country will remain choppy.

A slide in equities, currency and property could trigger a systemic risk. 

The renminbi has fallen nearly 3 percent in the offshore market within six trading days this year, and was down 2 percent in onshore trade. The spread between onshore and offshore market jumped to 1,900 basis points, compared with 1,200 points in the past.

Some foreign institutions have said that the currency could weaken further to 7.3 against the US dollar in offshore market in the next six months, and that the onshore yuan will ease to 7.2.

Currency concerns are leading to massive capital outflow. It is estimated that there is nearly US$1 trillion worth of renminbi in the country waiting to be transferred to other currencies.

A decline in foreign exchange reserves, meanwhile, will make the central bank think twice before undertaking any massive purchases of the yuan.

Amid mounting currency depreciation pressure, domestic residents might step up selling in the equity and property markets.

The stock market's benchmark index could tumble to 2,600 points if the renminbi slides 10 percent and triggers panic among retail investors. The panic could ripple into the property market, triggering a systemic risk.

The US dollar will maintain its strength in next two to three years due to Fed rate hikes. That could exert pressure on the Chinese currency and even push it to decade-lows.

The renminbi has appreciated from 8.27 to 6.04 against the US dollar since 2006, but now it is taking the opposite direction.

China's capital outflow might have reached around 10 trillion yuan last year, and the nation’s M2 supply is around 140 trillion yuan. The country's overall debt has increased by 10 trillion yuan, and its economic size is around 64 trillion yuan.

Given the various factors, the renminbi might tumble 10 percent this year, reaching 7.2 percent by the end of December from 6.55 at present.

The central bank has limited policy tools amid the economic slowdown. Interest rate cuts may help stimulate growth, but they could drag down the currency. Any major boost in money supply could also weaken the local unit.

China ETF volatility index has surged to 40 recently, above the average level of 30.

The stock and currency market slide in China is set to affect the Hong Kong market. The Hang Seng Index may drop to the 18,000-points level, after touching a low of 20,324 points last week. The Hang Seng volatility index rose to a worrisome level of 29.78 recently.

This article appeared in the Hong Kong Economic Journal on Jan. 12.

Translation by Julie Zhu

[Chinese version 中文版]

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adjunct professor in the Department of Finance at HKUST Business School