China’s devaluation dilemma

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Sara Salim's picture

In my previous article ‘The weak Renminbi explains the Chinese stock market sell-off’, I pointed out that weakness and volatility of the CNY was the main driver behind the equity sell-off episodes we have witnessed at the beginning of 2016. To prevent such volatile affairs from happening in the future, the Chinese authorities will have to address the markets’ concerns on the policy direction of the Renminbi.

The majority of market observers had assumed that the drain of FX reserves swiftly succeeding the initial devaluation of the CNY back in August 2015 would be temporary while a new equilibrium rate was found. Instead, the drains in reserves have unexpectedly accelerated right to the end of 2015. The Chinese authorities were possibly holding on to the hope that the market would see the lower CNY fixing in the beginning of 2016 as a mere function of the currency now tracking a basket of currencies, as opposed to only tracking the (really strong) USD. The equity sell-offs in the markets that followed shortly sought to exacerbate investors’ worries, which confirmed to them that CNY devaluation is a stock market red flag. Moreover, the weaker CNY impacts earnings for companies that are exposed to foreign exchange losses. Downgrades on Chinese equities only accelerated alongside rapid weakening of the CNY.

The unfortunate reality is that movements in the CNY is the main source of turbulence in Chinese stock markets. The CNY is faltering due to persistent capital outflows, FX reserve draw downs and downward pressure as a result of long-term overvaluation. These factors are playing out against a backdrop of likely monetary easing which will only cause the CNY to fall further against the USD. Theoretically if the fall in the value of the CNY is managed in a consistent manner with transparent guidance provided to the market, the impact on the stock prices should be minimal. This is currently wishful thinking since Chinese FX policy is (still) riddled with ambiguity.

We should take a step back and look at this problem from the perspective of the Chinese authorities. They are aiming toward: (i) A prominent reserve currency with functioning liquidity; and (ii) Economic growth that is reasonable. These goals are unfortunately mutually exclusive. There is a risk of a vicious cycle: if growth continuously undershoots expectations, it puts more downward pressure on the CNY.  Only when the CNY has traded at its much weaker equilibrium level, will this cycle be disrupted. So the ‘easy’ solution seems to be to let the CNY plunge to this equilibrium level. But to allow the CNY to plunge (instead of gradually depreciating), the Chinese authorities will be compelled to remove tight capital controls it enforces, which will cause an acceleration of capital outflows, consequently jeopardizing aim (i). Admittedly, China’s liquid reserves are more than adequate to control the CNY value in the near term, but if the weighty depreciation spirals out of control (which it usually does), the next round of equity market volatility will begin, and both aims (i) and (ii) are will be jeopardized.

If we witness another round of sell-offs, I believe it will be far more brutal than what we would have seen in previous episodes. Investors will exploit this opportunity to rapidly reduce exposure to Chinese equities as although the valuations are not approaching 2008 financial crisis lows, it is still historically cheap. Typically rallies of this sort should indicate a ‘buy’ signal. But since we are now witnessing the highest selling pressure over the past 15 years (excluding the period of the 2008 financial crisis), we can expect a short-term rebound at some point. What is certain is the need to compromise on ‘reasonable’ economic growth, because there will not be financial market (and economic) stability without Renminbi stability.