January macro indicators stay weak for China
The latest set of monthly macro indicators for China remained weak. Official manufacturing PMI corrected further below the expansionary mark of 50, to 49.8 in January, from 50.1 in December. On the trade front, both exports and imports suffered a larger-than-expected contraction. In particular, imports contracted considerably by 19.9% year-on-year. Trade data across Q1 is typically distorted by the volatile seasonal Lunar New Year effects. But the large contraction in imports does suggest continued weakness in domestic demand for China.
The month of January also saw a much weaker-than-expected set of inflation figures for China. Headline CPI declined to +0.8% year-on-year in January, from +1.5% year-on-year in December. This is the lowest headline CPI since late 2009. In addition, PPI contracted by a larger 4.3% year-on-year in January, from –3.3% year-on-year in December.
But local real interest rates remain elevated in China
The fall in headline inflation is frustrating the best efforts of the People’s Bank of China (PBoC) to ease monetary policy, resulting in local real interest rates remaining elevated in China. Irrespective of lower headline inflation, nominal money market rates also remain elevated as evidenced by the climb in the benchmark 7-day onshore repo rate from the 3% handle in November last year to about 4.5% now. The PBoC has acknowledged this situation by repeatedly highlighting the tight refinancing situation for local enterprises in China.
PBoC will need to ease monetary policy further
As such, due to the weaker set of macro indicators, coupled with lower inflation and stubbornly high real interest rates in China, the PBoC can be expected to ease monetary policy further. Previously in mid-November, the PBoC had made a pair of asymmetric cuts to both its lending and deposit rates, cutting its lending rate by a larger 40 bp compared to the 25 bp cut in the deposit rate, to 5.6% and 2.75%, respectively. And most recently in early February, the PBoC had also made a 50 bp cut in the Reserve Requirement Ratio (RRR) for large banks and corresponding RRR cuts for commercial and rural banks, releasing an estimated CNY 600 bn of liquidity into the local economy. Going forward, our macroeconomic team forecasts that the PBoC will need to deliver another 40 bp of interest rate cut to its lending rate, bringing it down from 5.6% to 5.2%. Additional RRR cuts are possible, but that is not their base-case scenario.
Initial signs of possible capital outflows from China
Amid ongoing concerns about the growth slowdown for China, there are also increasing signs of capital outflows. First, net direct investment flows is now decidedly negative. Growth for inbound Foreign Direct Investments (FDI) has slowed, while growth in outbound direct investments have surged, leading to the negative development in net direct investment flows.
Second, net FX flows from Chinese commercial banks confirm an acceleration of net purchases of USD. Third, China’s official FX reserves have contracted for a second consecutive quarter. We have been highlighting our concern about this contraction in FX reserves for some time now. China’s FX reserves fell by another USD 50 bn in Q4, following the larger USD 103 bn contraction in Q3. For now, most of the contraction in FX reserves can be explained by the FX revaluation losses of reserve assets held in reserve currencies other than the USD. Nonetheless, this is the first time in recent years that China’s FX reserves did not grow like clockwork on a quarterly basis.
Downgrading of CNY cycle view to neutral against USD
Existing supportive factors for the CNY remain in place. While China’s current account surplus is indeed lower compared to its peak a decade ago, it still remains a substantial 2% of GDP. As mentioned previously, the PBoC has put in place a total of 28 bilateral swap lines with leading global central banks, totaling CNY 3.1 trn. These swap lines will be supportive for the CNY in times of global market stress. China’s trade surplus remained strong and even rose to hit a new record monthly high of about USD 60 bn. On the surface, this strong growth in trade surplus is supportive for the CNY. However, we note that in recent months, the quality of the trade surplus has deteriorated, as it was generated due to steeper import contraction amid an export slowdown.
In addition, 2015 will see a marked expansion of offshore yuan centers across the world. Currently, there are only four offshore yuan centers in Hong Kong, Singapore, South Korea and Taiwan. Going forward, across the year, nearly ten more offshore yuan centers will be operational across the world, in key financial cities like London, Frankfurt, Paris, Luxembourg, Zurich, Sydney, Qatar, Toronto, etc. This is expected to result in further strong growth in CNH-related trade and investment demand.
On the other hand, as mentioned above, there is an increasing risk of further monetary easing from the PBoC, due to weakening macro indicators and lower inflation profile of China. There are also initial signs of capital outflows from China. On balance, we deem it prudent to downgrade our cycle view for CNY against the USD to neutral, from positive earlier.
CNY remains overvalued in REER terms
As we have highlighted for some time now, the CNY remains overvalued in terms of trade-weighted Real Effective Exchange Rate (REER) basis. This is a long-running concern for the CNY and implies that unless there is a significant recovery in China’s growth and activity, it would be difficult for the CNY to resume its previous appreciating path.
USD/CNY technical view remains broadly neutral
USD/CNY basically remains in a broad trading range between 6.11 and 6.27. Furthermore, the long-term 200-day moving average also remains in a sideways range. In addition, technical momentum indicators currently also do not favor a clear direction.Due to the aforementioned points, we reiterate our neutral technical view.
Instead of signaling outright depreciation of the CNY, the PBoC is likely to gradually raise the USD/CNY fixing rate. Further widening of daily trading band is also possible.
While we expect mild weakness ahead for the CNY, we note that it is unlikely and unnecessary for the PBoC to signal any outright depreciation of the CNY. While we note that the CNY is overvalued in REER terms, there is no clear need for China to depreciate the CNY as China still runs a good current account surplus of about 2% of GDP and has the largest FX reserve stockpile of USD 3.89 trn.
Furthermore, if expectations of a shift in the PBoC’s FX policy to that of outright depreciation take hold, it may trigger a further increase in capital outflows, thereby potentially destabilize China’s economy, just when the authorities are making strong efforts to stabilize growth. In addition, outright depreci ation of the CNY will be frowned upon by the IMF and China’s key trade partners and will be seen as taking a step back from ongoing efforts to reform and internationalize the currency.
In fact, at its recent Q4 monetary policy implementation report, the PBoC reiterated the need “to keep the yuan exchange rate basically stable at reasonable, balanced level” and added that it will aim “to increase the flexibility in yuan exchange rate.”
Therefore, instead of signaling outright depreciation, the PBoC may opt for a gradual lift of the USD/CNY fixing rate. A higher USD/CNY fixing rate is also in line with our expectations of a stronger DXY. Concurrently, the PBoC may well opt for a further widening of the daily trading band, to about +/- 3% from currently +/- 2% around the fixing rate. This is the flexible safety valve that the PBoC may utilize.
Currently, the USD/CNY fixing rate has been held relatively stable around 6.13. And at 6.25, the USD/CNY spot has been trading nearer to the weaker 2% end of the band due to the CNY weakness, relative to the fixing rate. Last March, the trading band was previously widened to +/- 2%, from +/- 1%.
As we get near the 1-year anniversary of last year’s trading band widening, the USD/CNY spot may in the weeks ahead trade higher to test the weaker 2% end of the band due to the CNY weakness on a sustained basis and the pressure for widening the trading band will grow. Strictly speaking, the motivation for the PBoC to widen the daily trading band this time round will be slightly different compared to last year. Back in last March, when the daily trading band was previously widened, the PBoC had stated very clearly that it was a necessary move to remove the “excessive one-way appreciation bet on the CNY” and also to inject “more two-way flexibility into the CNY.” This time round, there is clearly no excessive one-way appreciation bet on the CNY.
However, widening the daily trading band further would still go in line with the long-running goals of reforming the CNY exchange rate regime and allowing more market price discovery and enhancing two-way movements in the currency.
Overall, we see mild weakness in CNY to 6.33 against the USD.
In summary, given the weak macro indicators and lower inflation profile, there is increasing risk of more monetary easing from the PBoC. In addition, the CNY remains overvalued in REER terms. A higher USD/CNY fixing rate is possible, given the prevailing strong USD backdrop ahead of US interest rate normalization. While the PBoC is unlikely to signal any outright depreciation of the CNY, there are now increasing risks that the PBoC may instead guide the daily fixing rate gradually higher and possibly also widen the trading band as well.
Consequently, we move our overall view for the CNY to negative against the USD (from neutral previously) and see mild weakness in the CNY against the USD going forward.
We raise our USD/CNY point forecasts to 6.29 in 3M and 6.33 in 12M (from 6.22 currently for both 3M and 12M). Our USD/CNH point forecasts are implied to be similar to USD/CNY. The prevailing spot reference rate is about 6.24.
FX strategy implications
While we now forecast a mildly weaker CNY spot against the USD, we note that the FX market has already priced in a much weaker CNY in the Non-Deliverable Forwards (NDF), with the 1Y USD/CNY NDF trading at a higher 6.37. Similarly, the 1Y USD/CNH forward is currently trading at an even elevated 6.47. Implied volatility has also picked up noticeably over the past month, with both the 3M and 12M USD/CNY implied volatility jumping from about 2% and 3% from about 3% and 4%, respectively. Thus, it is now more expensive to hedge CNY or CNH weakness via the forward curve or using options.
Fortunately, both CNY and CNH offer relatively good carry of about 3.5%. This may help to mitigate the anticipated mild weakness in spot.
original source: http://online.barrons.com/news/articles/SB51367578116875004693704580466923609858124