Investors should brace for further yuan depreciation in March

January 23, 2016 08:00
The yuan could suffer further depreciation when the US hikes interest rates again in March. Photo: Bloomberg

Many investors appear to have panicked amid the turmoil in China's equity and currency markets in the past few weeks.

That shows that they still lack confidence in the nation's future growth and government efforts to stabilize the market.

The recent market chaos was caused in part by the limited experience, capabilities and professional expertise of the nation’s financial officials.

China’s financial market has become increasingly complex as a result of globalization.

However, most financial officials only have domestic experience. They lack the judgment and capabilities to deal with risks and ride through big financial storms.

A timely and thorough reform is the only option for China at present.

The country's astonishing economic growth in the past several decades has left behind various issues.

The government's resolve to press ahead with financial reforms is the key to restoring trust and confidence among investors.

It appears that the currency is the biggest risk to China’s financial safety. The country's foreign exchange reserves have dropped to US$3.3 trillion recently from nearly US$4 trillion.

Professor David Li Daokui, director of the Center for China in the World Economy at Beijing's Tsinghua University, said authorities should keep a tight grip on the capital accounts given the rapid and massive capital outflow.

They should maintain foreign exchange reserves at above US$3 trillion, Li said. If China’s foreign exchange reserves fall below US$3 trillion, it could trigger a self-inducing expectation for a weaker yuan.

The government should tighten oversight over large state-owned enterprises, particularly those centrally controlled, and see to it that domestic organizations with offshore branches do not engage in cross-border arbitrage.

China only has US$300 billion of foreign exchange left to defend its currency.

Beijing has asked mainland organizations in Hong Kong to buy renminbi using their foreign exchange.

That has led to rapid rebound in the Chinese currency in recent days. However, the move is quite controversial.

What happens when these organizations run out of foreign exchange? Who would assume responsibility as they exchange foreign exchange into renminbi, a move that could put pressure on their balance sheets and operations? How would they explain their action to shareholders?

The renminbi is expected to stabilize for now amid Beijing’s support. But the currency could still suffer further depreciation two to three months later, when the United States hikes interest rates again in March.

Eventually, the government may impose stringent capital controls for fear of accelerated capital flow and rampant speculation in the offshore market.

If this happens, it could be a setback to Beijing's efforts to internationalize the renminbi.

The overnight CNH-Hibor rate surged by 120 basis points recently, and this has considerably raised the costs of speculating on the yuan.

That would force short-sellers to leave the market. However, the record-high Hibor rate reflects the stretched yuan liquidity in the offshore market.

That could have a ripple effect on the renminbi business in the city, such as the dim sum bond.

Thus, the city’s renminbi business is also at risk amid the recent yuan depreciation.

This article appeared in the Hong Kong Economic Journal on Jan. 19.

Translation by Julie Zhu

[Chinese version 中文版]

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adjunct professor in the Department of Finance at HKUST Business School