Chinese Yuan’s Double Whammy - Dollar Strength and Yen Weakness

• USDCNH however retreated today after an initial jump to 7.28, as yuan was supported by intervention
• China’s Q1 GDP came out strong on the headline at 5.3% YoY (vs. 4.8% expected and 5.2% prev), but details were weak
• Industrial production and retail sales for March much weaker than expected, suggesting that more stimulus will be needed.

   

  What does it mean?

• On the economy, key driver is still external demand, consumption and property sector remain key challenges.
• In order to drive exports, Chinese authorities will need to keep yuan stable-to-weak, rather than let it strengthen.
• Meanwhile, unrivalled dollar strength is putting pressure on yuan and making it difficult for Chinese authorities to defy gravity.
• Yen weakness is another reason why China cannot let yuan strengthen. Weaker Japanese yen makes Japanese exports more competitive in export markets relative to China. CNHJPY is key to monitor for this, and a break above 21 is a red flag.

   

  Could we see a yuan devaluation?

• In August 2015, China devalued the yuan in a move that rippled through global markets, as policy makers stepped up efforts to support exporters and boost the role of market pricing. The central bank cut its daily reference rate by 1.9 percent, triggering the yuan’s biggest one-day drop since China ended a dual-currency system in January 1994. The People’s Bank of China called the change a one-time adjustment and said its fixing will become more aligned with supply and demand.
• It is worth considering whether another such move may be likely, given the pressure on the Chinese economy and export being a key engine driving growth for now. Domestic price pressures also remain at bay, suggesting a weaker currency wouldn't hurt consumers too much.
• However, Chinese policymakers are trying to steer global consumers away from the notion that made-in-China is simply cheaper, hence more attractive. Authorities also likely want to avoid exacerbating capital outflows, and hurting investor and consumer confidence further. This could mean a competitive devaluation is avoided. However, steadily higher midpoint fixings for USDCNY can make the yuan weakness more orderly.

Spillover effects of a weaker yuan

• Risk-reward remains titled towards further weakness in Chinese yuan after it has traded steadily for four months.
• USDCNH could rise towards 7.30 if weak CNY fixings continued.
• CNHJPY is likely to revert to sub-21 handle.
• Positioning for a weak yuan in light of the US election risk is also interesting, especially as it provides a positive carry.
• A weaker yuan could add further fuel to the dollar fire, and make dollar gains more durable.
• This could be negative for emerging Asia currencies such as KRW and THB.
• Commodity and China-dependent AUD may also be at risk if yuan weakness extends further.
• A spike in yuan volatility would also likely disrupt carry trades – where investors borrow in low-yielding currencies to invest in higher-yielding ones, typically in emerging markets. An ideal funding currency is one with low volatility and relative stability – both of which are satisfied by the yuan, but that may not be the case for much longer.

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