Will the Chinese Year of the Goat see a prolonged weakness in the yuan by the People’s Bank of China? (PBOC) The yuan fell 3% against the U.S. dollar between October 2014 and mid-February 2015, and lost 4% during the first five months of 2014. Regardless of whether China tackles its slowing economy via further monetary easing or fiscal stimuli, we anticipate additional decline of 5%-7% in the currency, reaching toward 6.60 yuan per 1 U.S. dollar.
The 19% year-over-year slump in China’s January imports was the biggest decline since May 2009 and the seventh decrease over the last 12 months. The plunge in imports was the primary driver behind the new record high trade surplus of $60 billion as exports fell 3.3%, posting their first decline in 10 months. Disappointing China figures ahead of G20 meetings are far from rare, but the long term trend in the data is another reminder that Beijing will cut its benchmark lending/borrowing rates and pave the way for further CNY depreciation, which Western lawmakers can do little about.
Can’t blame it on the goat
Chinese currency watchers could be tempted to attribute any sharp swings in January and February data to distortions relating to the Chinese Lunar New year holiday. But this holiday (Year of the Goat) isn’t scheduled to start until mid-February, leaving January immune from holiday stoppages. And the recent consistency of the decline in Chinese imports – not seen since the 2008-09 crisis — has been partly a result of slumping commodity prices. Later this month, the Hong Kong trade figures will reveal whether China’s trade data is a reflection of real trade flows rather than over-invoicing.
Discussion among Chinese central bank researchers and less vocally by International Monetary Fund (IMF) economists increasingly reflects the idea that further yuan weakness is the only solution for stabilizing the prolonged decline of consumer and producer price inflation, while helping to alleviate the decline in exports. It is no longer the case that U.S. lawmakers have the political capital and economic reasoning to urge China into further yuan appreciation. The IMF views China’s currency to be more appropriately valued, while U.S. lawmakers lack the standing to pressure Beijing over its currency after three rounds of USD-depreciating quantitative easing and one round of the Federal Reserve’s Operation Twist during the last six years.
My expectation for further CNY weakness ahead is not only based on the glaring Chinese slowdown (GDP, industrial output and personal consumption), but also by the record deficit in the nation’s capital and finance account balance. Together, these indicate persistent declines in hot money flows and foreign direct investment.
The prolonged divergence between the PBOC’s USD/CNY reference rate and interbank rates highlights that CNY weakness will continue ahead, either via a widening of the daily fluctuation from its current +/-2%, or a defacto devaluation (see “Dislocation”). Most likely the former option will prevail as Beijing adopts the free market route toward policy easing.
Weaker yuan will export deflation
As China’s currency further depreciates, the cost of its goods will appear cheaper to European and U.S. importers to the extent of exacerbating an already disinflationary environment; outright deflationary in the Eurozone. With policy rates at negative levels in the Eurozone, Japan, Switzerland, Denmark and Norway, more is expected to come in Canada, Australia and possibly New Zealand. Global monetary policy is already spelling deflation. For as long as the Federal Reserve and Bank of England keep up appearances of signalling a rate hike, their currencies will firm until the threat of deflation is no longer seen as “transitory.”
The United States runs the risk of importing deflation via the soaring U.S. dollar. If this occurs, the Fed will be forced to postpone its first rate hike, now expected by bond traders to occur as early as Q2 2015. We do not see a rate hike at all this year.
Further yuan weakness will emerge alongside the further erosion in commodities, already seen in metals and energy. The 30% decline in the Aussie since summer 2011 is only the first half of the retracement of the 2001 to 2011 rally. Another 35% is possible over the next two years.