How much should we worry about the Yuan?

Yvan Berthoux - 24 January 2019

Slowing global growth, quantitative tightening and a slower pace of real money growth weighed heavily on global equity prices in the final quarter of 2018. In addition, unsettling data developments in China coupled with tightening conditions in the corporate bond market have forced the PBoC to cut interest rates and undermined market assumptions about currency stability. How much should we worry about USDCNY in 2019?

Last weekend, China’s National Bureau of Statistics reported that economic growth ticked down to 6.4 per cent in the fourth quarter, leaving the official version of 2018 growth at its weakest in 28 years.  However, economists have complained for many years that China tends to overestimate its GDP growth rate. For example, the Chinese Academy of Social Sciences has argued that a more accurate estimate of Chinese real GDP growth rate is obtained by multiplying the annual change in industrial production by 0.7.

Figure 1 (left chart) shows that the time series (real GDP and adjusted IP) co-moved very closely between 1992 and 2012 but have diverged subsequently. According to the adjusted IP measure, China has slowed more significantly than portrayed in the official data, to an annual pace of around 4 per cent. A possible explanation for the divergence is the explosive growth of the digital economy.

Most recently, Chinese exports and imports collapsed in December, falling by 4.4 per cent and 7.6 per cent YoY, respectively, indicative of a deterioration in global goods demand. In figure 1 (right frame), we observe that the fall in the trade data was largely anticipated by the deterioration in the Citi Economic Surprise Index for the G10 economies (using a 6-month lead), especially in the Euro area, and the uncertainty around the trade war. Hence, further deterioration in the Chinese economic activity could weigh on global equities and some commodities in the course of this year.

Another revealing chart is the annual change in Total Social Financing, a broader measure of credit, overlaid with a 6-month lead with the annual change in global equities (figure 2, left frame). While there are many candidates to explain the weakness in global equity prices – US quantitative tightening, falling global real money growth (M1) and a rise in uncertainty – the slowing pace of Chinese credit expansion may also have played a part.  Figure 2 (right frame) shows that the weaker-than-expected Chinese economic data has frequently influenced equity performance over the past few years. The Shanghai Stock Exchange sits currently at critical levels with investors’ risk appetite standing at extreme lows.

As real (M1) money growth has fallen over the past few years, China’s excess liquidity has contracted, adding further pressure to both equity and the property markets. Figure 3 (left frame) shows that excess liquidity tends to lead (by 9 months) house prices in China. Empirical studies have estimated that a 10 per cent decline in demand for real estate and housing-related construction could lead to a 2-percentage-point fall in economic output.

In the credit market, we saw an important divergence in the borrowing costs between AAA and AA- rated bonds (figure 3, right frame). While the yield on 5-year AAA bonds has tracked the fall in government yields over the past year, borrowing costs for AA- rated bonds have remained flat at around 7 per cent due to the rise in corporate defaults in 2018 (totalling CNY157bn, more than the combined total for 2014-2017). Even though corporate defaults still represent less than 1 percent of the outstanding market (US$4bn), investors should beware the corporate bond market this year, and especially the non-state-owned companies (usually rated AA- and below).

Therefore, to reverse investor sentiment, Chinese officials must sustain an accommodative stance regarding the liquidity injections from the PBoC and the required reserve ratios (RRR) for most commercial banks. As shown in figure 4, left frame, while the Fed has maintained its tightening policy in 2018, hiking its target rate four times, China reduced its RRR four times (including January 2019 cut).

While the RRR-Fed Funds differential is irrelevant in terms of ‘carry’, the abrupt depreciation of the Chinese Yuan last year, taking the USDCNY spot rate from 6.25 to almost 7, penalised speculative activity in Chinese assets. If Chinese policymakers fail to shore up domestic asset prices and reassure investors, then the exchange rate could easily retest and eventually break the psychological resistance level of 7, which would tighten financial conditions in the US Dollar-denominated bond market. For now, the softening Fed stance has alleviated CNY pressure, but we cannot dismiss the possibility of the USDCNY breaking the psychological 7 level this year.

Figure 1

Data Source: Eikon Reuters, Datastream

Figure 2

Data Source: Eikon Reuters, EP

Figure 3

Data Source: Eikon Reuters, DataStream, CEIC

Figure 4

Data Source: Eikon Reuters


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