The PBOC’s taken stock
Of how their maneuvers did rock
Most markets worldwide
Which helped them decide
More currency weakness they’d block
The Chinese renminbi remains the number one story and concern in all financial markets as investors and traders try to decipher the meaning of yesterday’s move to allow a much weaker currency, but more importantly how those actions will help drive future activities.
As always, there are two sides to every coin, in this case both figuratively and literally. From the perspective of China’s manufacturing and production capabilities it is very clear that a weaker renminbi is a benefit for its exporters. Chinese goods are that much cheaper this morning than they were Friday afternoon. This, of course, is why there is so much concern over any nation weakening their currency purposely in order to gain an advantage in trade. This is the ‘beggar thy neighbor’ policy that is decried in both textbooks and political circles. It is this idea that animates President Trump’s complaints about a too strong dollar hindering US manufacturing exports, and it is true, as far as it goes.
But it is not the whole story by a long shot. There are two potentially significant negative consequences to having a weaker currency, both of which can have significant political as well as economic impacts. The first, and most widely considered is rising inflation. Remember, if a nation’s currency weakens then all its imports are, relatively speaking, more expensive for its citizens. While small fluctuations in price may be absorbed by businesses, ultimately a steadily weakening currency will result in rising prices and increases in measured inflation. This is one of the key things that BOE Governor Carney worries about in the event of a hard Brexit, and the only reason he tries to make the case that interest rates may need to rise after Brexit. (p.s., they won’t!)
However, the other issue is generally less considered but often far more destructive to a nation. This is the problem of repayment of foreign currency debt. Remember, the US capital markets are far and away the largest, deepest and most liquid in the world, and thus companies and countries around the world all raise funding in USD. Even though US rates are high relative to the rest of the G10, that available liquidity is something that is not replicable anywhere else in the world and offers real value for borrowers. And of course, compared to many emerging markets, US rates are lower to begin with, making borrowing in dollars that much more attractive. But when another country’s currency weakens, that puts additional pressure on all the businesses that have borrowed in USD to fund themselves (and the country itself if it has borrowed in USD).
For example, according to the BIS, Chinese companies had outstanding USD debt totaling more than $1 trillion as of the end of 2018, and that number has only grown. As the renminbi weakens, that means it takes that much more local currency to repay those dollars. China has already seen a significant uptick in local bankruptcies this year, with CNY bond defaults totaling nearly $6 billion equivalent and the pace increasing. And that is in the local currency. When it comes to repaying USD debt, a weaker CNY will just exacerbate the situation. The PBOC is well aware of this problem. In fact, this issue is what will prevent the PBOC from allowing the renminbi to simply fall and find a new market clearing price. Instead, they will continue to carefully manage any further devaluation to the best of their ability. The problem they have is that despite their seemingly tight control of the market, they have created an offshore version, the quickly growing CNH market, which is far more costly to manage. In other words, there is a real opportunity for leakage of funds from China and an uncontrolled decline in the currency, or at least a much larger decline than planned. We are only beginning to see the impact of this move by the PBOC and do not be surprise if things get more volatile going forward.
But this morning, the PBOC remains in control. They fixed the onshore CNY at 6.9683, stronger than expected and in the FX market CNY has regained about 0.3% of yesterday’s losses. This stabilization has allowed a respite in yesterday’s panic and the result was that Asian equity markets rebounded in the afternoon sessions, still closing lower but well off session lows. And in Europe, the main markets are all marginally higher as I type. It should be no surprise that US futures are pointing to a modest uptick on the opening as well.
In the bond markets, Treasury prices have fallen slightly, with yields backing up 2bps. The same movement has been seen in Japan, with JGB’s 2bps higher, but actually, in Germany, yields continue to decline, down a further 3bps to yet another new record low of -0.54% as German data continues to exhibit weakness implying the Eurozone is going to fall into a recession sooner rather than later.
Finally, in the rest of the FX market, we are seeing a modest reversal of some of yesterday’s significant moves. For example, USDMXN is softer by 0.2% this morning after the peso fell nearly 2.0% yesterday. We are seeing similar activity in USDBRL, and USDKRW. These examples are just that, indications that an uncontrolled collapse is not in the cards, but that this process has not yet played itself out. In the G10 space, the RBA left rates on hold at 1.00% last night, as universally expected, and Aussie has rallied 0.4% this morning. Interestingly, one of the reasons they felt able to pause was the fact that the AUD had fallen more than 3% in the past month, easing financial conditions slightly and helping in their quest to push inflation back to their target. The other reversal this morning has been USDJPY which is higher by 0.4% after having traded to its lowest level (strongest JPY) yesterday since March 2018. As yen remains a key haven asset, it remains an excellent proxy for risk appetite, which today is recovering.
There were actually a few Fed speakers yesterday with both SF President Daly and Governor Brainerd expressing a wait and see attitude as to the impact of the escalation of trade tensions, although a clear bias in both cases to cut rates. Meanwhile, the futures market is pricing in a 100% chance of a 25bp cut in September and a 40% chance of a 50bp cut. It seems like the Fed has a lot of work to do in order to clarify their message.
With no data of note today, the FX market is likely to continue to consolidate yesterday’s moves, and awaits comments from James Bullard, St Louis Fed President and noted dove. In the end, my sense is that the Fed has lost control of the situation and that we are going to see more rate cuts than they had anticipated going forward. The question is more the timing than the actuality. In the meantime, the dollar is likely to be dichotomous, continuing to rise vs. the EMG bloc, but faring less well vs. much of the G10.