China easing as data softens

China’s decision over the weekend to cut the required reserve ratio (RRR) by 100bp (effective Oct 15), the fourth cut this year, will inject around CNY 750bn in liquidity into China’s money markets. The decision to ease comes in the wake of a run of recent soft data.   There should be no big surprise.  China is reluctant to ease policy via a policy rate cut to avoid fuelling any increase in leverage and therefore continues to embark on targeted easing in the form of RRR cuts.

It is likely that further RRR cuts in addition to fiscal stimulus are in the pipeline to cushion the slowdown in the economy.   Indeed, growth was already slowing before the US tariffs impact bites and will likely slow further in the months ahead as the impact of tariffs has a greater effect.   Recent forward looking data including the official and CAIXIN purchasing managers’ indices (PMIs) of manufacturing confidence have softened, with the exports component of the PMIs dropping significantly.

Such cuts will weigh on China’s currency, CNY/CNH and a continued spot depreciation versus USD is likely.   After its sharp decline in June/July FX the PBoC has succeeded in stabilising the CNY (in trade weighted terms) however.   Any decline in foreign exchange reserves has been limited as reflected in the latest FX reserves data, which revealed that FX reserves dropped by $22.7bn only in September, suggesting that as yet there have not been significant capital outflows (ie panic) from China and limited need for FX intervention to support the CNY.

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Worsening China Economic News

There was more bad news on the data front from China.  Data released yesterday revealed a further slowing in the manufacturing sector. The Caixin purchasing managers index (PMI) dropped to 50.0 in September, its lowest reading since May 2017. This index which is far more weighted towards smaller companies is more sensitive to export concerns. Further pressure on sentiment is likely over coming months as tariffs bite, with prospects of another $267bn of US tariffs against China still very much alive.

The official China manufacturing PMI fell to 50.8, its lowest since February 2018, from 51.3 in August. Reflecting worsening trade tensions, the new export orders component of the index fell to 48, its fourth consecutive contraction and lowest reading since 2016. In contrast the non-manufacturing PMI strengthened to 54.9 from 51.2 in August reflecting firm service sector conditions. S

Separately China’s central bank, the PBoC stated on Saturday that it will maintain a prudent and neutral monetary policy stance while maintaining ample liquidity. This implies further targeted easing. The data may fuel further pressure for a weaker Chinese currency path in the weeks ahead though it is unlikely that China will revert to the fast pace of CNY depreciation registered over June.

 

Trade war heats up

After the US administration announced that it will impose tariffs on $200 billion of Chinese imports to the US, China responded by announcing retaliatory tariffs on $60 billion of US goods.

The US tariffs of 10% will be implemented on September 24.  The tariffs could rise to 25% by the beginning of next year if no deal is reached between the US and China. This is important as it implies some breathing space for a deal and means that the immediate impact is less severe.

There have been some exemptions on goods that were on the original list including smart watches and Bluetooth devices. Aside for allowing time for negotiation the delay in increasing to 25% to 1 Jan 2019 also gives US manufacturers time to look for alternative supply chains.

The reality is that these tariffs should not be surprising. There has been little room for compromise from the beginning. China wants to advance technologically as revealed in its “Made In China 2025” policy as part of its efforts to escape the so-called middle income trap by fostering technological progress and movement up the value chain.

In contrast the US clearly sees China’s policy as a threat to its technological dominance especially as the US holds China responsible for intellectual property theft and forced technology transfers.US administration hawks including trade advisor Peter Navarro and US trade representative Lighthizer were always unlikely to accept anything less than a full blown climb down by China, with moderates such as Treasury Secretary Mnuchin and head of the National Economic Council Kudlow unable to hold enough sway to prevent this.

President Trump stated that if China retaliates the US will pursue further tariffs on the remainder of $267bn of Chinese imports. This now looks like a forgone conclusion as China has retaliated.

Further escalation from China could target US energy exports such as coal and crude oil. China could also target key materials necessary for US hi-tech manufacturers. Another option for China given the lack of room for tit for tat tariffs is to ramp up regulations on US companies making it more difficult to access Chinese markets. It could give preference to non-US companies while Chinese media could steer the public away from US products. Such non trade measures could be quite impactful.

It seems unlikely that after allowing a rapid fall in the renminbi (CNY) and then implementing measures to stabilise the currency (in trade weighted terms) China would allow another strong depreciation of the CNY to retaliate against US tariffs. Even so, as long as China can effectively manage any resultant capital outflows and pressure on FX reserves, it may still eventually allow further CNY depreciation versus the USD amid fundamental economics pressures.

Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

Risk appetite firms

Despite the decision by Crimea’s parliament to formally request accession to Russia markets risk assets performed well overnight, with US and European equity markets registering solid gains. Consequently US yields rose overnight while the USD made gains against safe haven currencies.

Market relief probably reflected the fact that the referendum itself passed without violence while the reaction by the West in terms of sanctions was not seen to have a particularly detrimental impact on sentiment.

China’s decision to widen its currency band also passed with little fanfare given that such a move was largely anticipated. There will be some positive pass through into the Asian session from the gains in asset markets overnight although a degree of caution continues to be warranted given the still precarious situation in the Ukraine and ongoing tensions between Russia and the West.

What now for the CNY?

News that China doubled its currency band (to 2% from 1% in relation to its daily mid point) will have reverberations across markets but the reality is that China has been building up to this for several weeks and now that it has happened there may be little incentive to push for more currency weakness.

The net result will probably be less volatility after an initial knee jerk reaction and some relief in markets that the China has actually gone ahead with the move after so much speculation. The reaction of the CNY is set to follow the same script as April 2012, with volatility set to ease once the initial reaction fades.

The weakness in the CNY had been engineered to incite more two way risk to a currency that for many months had been on a one way path of appreciation. China had been forcing the CNY weaker over recent weeks in order to deter speculators who had taken significant long positions in the currency playing for further currency strength.

CNY depreciation versus the USD (around 1.5%) since mid February may also have been a reflection of weaker economic data, with China releasing a series of data releases that had missed consensus forecasts, especially recent trade data.

Already both implied and realized USD/CNY volatility has been trading well in excess of past moves (as reflected in statistical significant readings in our Z-score analysis). Additionally risk reversal skews (3 month, 25 delta) have been flirting with its 2 standard deviation band indicative of the view that the options market holds an extreme view of CNY downside risks.

The main imponderable is what China does now. The band widening is clearly a further step along the road of freeing up the currency on the road to capital account convertibility. However, the reality is that the Peoples Bank of China (PBoC) still sets the daily fixing and the movement in the CNY will still largely depend on where this fixing is set.

Ultimately a move towards a more market based currency will need to allow the market to determine the level and movements in USD/CNY. This may still be a long way off. In the meantime it seems unlikely that the authorities will intervene as aggressively to weaken the CNY as they have done in recent weeks, with a breach of USD/CNY 6.15 likely prove short lived.

China’s still healthy external position and likely resumption of capital inflows will mean that appreciation pressure on the CNY will return and a move back to around 6.00 by end 2014 remains on the cards.

Asian currencies weaken

Asian currencies are facing pressure today in the wake of a generally firmer USD tone although the fact that US Treasury yields continue to edge lower will provide some relief. There has been some good news on the flow front, with the region registering a return of equity portfolio flows so far this month to the tune of USD 1.56 bn, with all countries except Vietnam registering equity inflows. Notably however, India has registered strong outflows of equity capital this week, which could cap gains in the INR.

Weakness in the CNY and CNH has been sustained with the USD grinding higher against both. Recently weaker economic news and expectations of some form of policy measures on the FX front (perhaps band widening) soon after the end of the National People’s Congress will keep the CNY and CNH under pressure.

March’s biggest outperformer the IDR has been an underperformer overnight although its drop has been small compared to the magnitude of recent gains. Nonetheless, USD/IDR may have found a tough level to crack around 11400.

The INR is set to trade with a marginally weaker tone but further direction will come from today’s releases of January industrial production and February CPI inflation data. A move back to 61.50 for USD/INR is likely unless the data comes in strong.

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