Yuan Drop Not Over for Bears as Currency War Blunts Devaluation

  • Real effective exchange rate is within 1% of record high
  • SocGen strategist sees 20% drop versus dollar within 18 months

A gauge of the yuan’s strength is almost back to where it was prior to August’s surprise devaluation, spurring speculation China will reenter a global currency war.

The real effective exchange rate is within 1 percent of a record high and has risen almost 20 percent over two years, according to a Westpac Banking Corp. index. President Xi Jinping’s economic growth goal of 6.5 percent for the next five years won’t be met unless the yuan falls at least 8 percent versus the dollar by the end of 2016, Royal Bank of Canada and Rabobank Groep said. Albert Edwards, a global strategist at Societe Generale SA, predicts China will let its currency slide more than 20 percent within 18 months.

"A strong currency imports deflation and we are in a beggar-thy-neighbor currency war," said Edwards, who had been calling for a yuan devaluation for at least 18 months before the Aug. 11 move. "A Chinese devaluation will prompt additional knee-jerk devaluations elsewhere in the region, but the Chinese have little choice but to participate."

Strong Yuan Hurts Exports

Interest-rate cuts have borne the brunt of China’s efforts to tackle the slowest economic growth in 25 years, with policy makers favoring a stable yuan to support its entry into the International Monetary Fund’s basket of official reserve currencies. Intervention has burnt through more than $300 billion of foreign-exchange reserves this year and the case for propping up the yuan will weaken once a Nov. 30 IMF vote formalizes China’s inclusion in the lender’s Special Drawing Rights.

While the yuan has declined 2.8 percent this year to 6.3840 a dollar in Shanghai, its real effective exchange rate has gained 3.8 percent as the currency strengthened against 26 of 31 major counterparts, Bloomberg data show. Bloomberg Intelligence economist Fielding Chen estimates every 1 percent increase in the gauge will lead to a similar decline in exports, which fell in all but two of the past 10 months.

‘Reduced Competitiveness’

China’s overseas sales fell 6.9 percent from a year earlier last month in dollar terms, official data show. Gross domestic product is expected to increase 6.9 percent this year, which would be the smallest gain since 1990, and gains are seen moderating to 6.5 percent in 2016 and a below-target 6.3 percent in 2017, Bloomberg surveys show.

"The trend weakness in export and import growth partly reflects weaker external demand, but it also underscores China’s reduced competitiveness and the need for the PBOC to tolerate a weaker yuan," said Sue Trinh, head of Asia foreign-exchange strategy at Royal Bank of Canada in Hong Kong. "The government’s target looks far too high without the help of further stimulus, both fiscal and monetary –- which includes the exchange rate."

Trinh, who predicted the yuan would weaken before the August devaluation, said the currency is overvalued by 16 percent versus the greenback and forecast it will end next year at 6.95 a dollar. Strategists at Rabobank Groep and Daiwa Capital Markets predict slides of at least 15 percent for the coming year.

‘Deceptively Stable’

IMF Managing Director Christine Lagarde said late Friday that her staff have recommended the yuan be included in the SDR basket, along with the dollar, euro, British pound and yen. The inclusion implies that China will continue to liberalize its capital account and reduce intervention in the currency market, Claudio Piron, co-head of Asia rates and foreign-exchange strategy at Bank of America Merrill Lynch, wrote in a note Monday.

"The yuan could be deceptively stable over the next couple of weeks but reduced intervention and a more flexible fixing would inevitably be associated with a weaker currency," said Piron. "We would potentially look to add to offshore yuan shorts soon after the SDR decision on Nov. 30."

China should speed up yuan convertibility under the financial and capital accounts, because that is important to get the currency ready for greater global usage, Caixin magazine reported, citing Zhou Chengjun, an official at the PBOC’s monetary policy department. A more open capital account will pressure the yuan lower in the short run due to China’s weak fundamentals, although it will attract inflows in the medium to long term, according to Oversea-Chinese Banking Corp.

Yuan weakness won’t be a cure-all savior for China’s economy, the growth of which will likely be funded by an expansion of credit, said Becky Liu, senior Asia rates strategist at Standard Chartered Plc. in Hong Kong. That’s because sharp declines in the Chinese currency will drive other exchange rates in the region lower, supporting the yuan in real terms, she said.

The PBOC will have to cut its benchmark lending rates by another 75 basis points and banks’ reserve-requirement ratios by 200 basis points by end-2016 to stabilize growth, Koon How Heng, a senior foreign-exchange strategist at Credit Suisse AG’s private banking and wealth management unit in Singapore, wrote in a note Monday.

The yuan, which is "very overvalued on a REER basis," will trade around 6.60 versus the greenback six to 12 months from now, he said.

— With assistance by Tian Chen

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