CNY: a hedge against political uncertainty int he west?

Yvan Berthoux - 04 June 2020

In stark contrast to the US Federal Reserve, that has expanded its balance sheet by nearly US$3.5tr in the past few months in response to the Covid19 crisis and the potential deflationary pressures, the PBoC ’s balance sheet has remained steady at CNY36tr (US$5.06tr). Logically, the Fed’s aggressive liquidity injections predispose the US Dollar to weakness against a broad spectrum of currencies in the coming months. While the USD has yielded a little ground against major currencies, such as the Euro and the Japanese Yen, it has remained steady against the CNY. Potential drivers of Yuan strength are higher interest rates, a sharper recovery profile relative to the western economies and less exposure to political uncertainty.
Figure 1, left frame, shows the performance of selected currencies against the USD over the past 10 weeks. While it is hardly a tight relationship, figure 1 (right frame), the Fed-PBoC balance sheet differential is indicative of a strengthening Yuan. However, we argue that a more convincing argument for Yuan appreciation derives from the interest rate outlook and the prospect of a much more vigorous rebound in Chinese economic activity than in the West.  

Figure 1

Data source: Eikon Reuters

Figure 2 (left frame) shows that one of the major drivers of the USDCNY exchange rate has been China’s Required Reserves Ratio (RRR) – Fed Funds Rate (FFR) differential. In pursuit of a notional real GDP growth target of more than 6 per cent, the PBoC has almost halved its RRR in the past 5 years, from 20 per cent to 11 per cent, helping to weaken the CNY. However, the Fed reached the zero interest rate bound (again) in March in response to Covid-19, and therefore the positive carry between the two currencies could attract trades that support the CNY.
In addition, US long-term yields have fallen dramatically relative to China in the past 18 months; figure 2 (right frame) shows that the 10Y US-China IR differential is currently pricing in a much stronger Yuan.

Figure 2

Data source: Eikon Reuters

The second important driver of currencies in the long run has been the real GDP growth differential. The current political instability in the US could dampen the ‘recovery’ profile, leading to disappointing growth prints in the coming quarters: according to the Atlanta Fed, real GDP is expected to plummet by 17.2 per cent in the second quarter. In China, after dropping by 6.8 per cent in Q1 (figure 3, left frame), growth is rebounding already.
China, and other Asian economies (e.g. South Korea and Japan), are better-placed to ride out the Covid-19 storm, both economically and politically, as civil unrest erupts in US cities and in Hong Kong.  The prospective strength in the Chinese Yuan may also attract inflows into domestic equities in the near to medium term. Figure 3 (right frame) shows a interesting co-movement between the CNYJPY exchange rate and the Shanghai Stock Exchange (SSE) composite over the past 25 years.

Figure 3

Data source: Eikon Reuters, EP


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