Chinese yuan rare weakness

The Chinese yuan is down for the 5^th straight session. Having posted its biggest weekly decline vs. the US dollar since January 2012, the yuan closed Monday on another downnote. It is the first string of four consecutive weekly declines since May-June 2012, a period coinciding with a 10% sell-off in the S&P500—the last time the US index fell by such magnitude. 

It is especially rare for China to allow prolonged weakness in its currency ahead of international summits such as the weekend’s G20 meeting in Sydney, where the US, Canada (and sometimes Europe) pressure Beijing to allow further CNY liberalization (weakness).

2- way volatility

One possible explanation for CNY’s weakness reflects efforts from the People’s Bank of China to encourage 2-way volatility ahead of next month’s National People’s Congress and affirm that the currency is not a one-way bet. That would be required if the capital account is to be further liberalized and foreign bank trading participation encouraged. CNY weakness in the past has also been used to ease speculative activity and excessive capital inflows.

The CNY chart below shows the currency has appreciated 25% against the USD since Beijing revalued the currency in July 2005. The increase emerged in 2 phases: a 15% rise from July 2005 to July 2008; and an 11% rise from 2008 to now. The latter phase was widely part of the campaign to internationalize the currency in global markets. So is the yuan done appreciating?

Exceptions occurred when China experienced a period of marked slowdown, in which case would justify a weaker yuan –or slowdown the pace of appreciation.  Recent data have indeed shown weakness. January services PMI fell to 53.4, the lowest figure on record over the past 3 years of the index, while the manufacturing PMI fell to 50, the lowest since July of last year.

Unrelated to Dalai Lama-Obama meeting

Some have speculated that Beijing’s action in weakening its currency may be aimed at the US in protest at president Obama’s meeting with Tibetan spiritual leader Dalai Lama. In none of Obama’s two meetings with Dalai Lama in 2010 or 2011 has China gone as far as freezing diplomatic relations with Washington as it has done with the UK when PM Cameron met with the spiritual leader in May 2012. Has Beijing reached the end of the line with Washington?  Is it starting its own war of currencies?

Trust product solvency

Another possible culprit maybe the decline in Chinese bond yields to be causing investors to exit the CNY-carry trade.  The prolonged slowdown in China’s economy is complicating the solvency of trust credit products tied to the mining industry, and thereby impacting the credit chain. Despite perceptions of Beijing’s capacity to bailout these financial institutions, there is a limit onto how far it can go. China’s 5-year credit default swap has climbed over 20-bps from December lows. The next warning may come in the form of a ratings outlook downgrade from a major credit rating agency.

EM’s inffective double standard

Two years after emerging market nations blamed the Federal Reserve’s quantitative easing policy for the excessive run-up in the value of their currencies via deepening decline in the USD, leaders of some emerging market economies are blaming the Fed’s tapering of asset purchases on the volatility and decline in their currencies. The argument that the Fed’s $20 bn tapering of its monthly asset purchases has diverted away capital from bonds to the rising yields of US treasuries is one avenue of criticism. As expected, China and Europe have supported the Fed’s normalization policy and urge emerging markets to clean house internally.

The next bout of EM selloff could likely resurface in mid Q2 on concerns over the policy normalization from the world’s biggest economy may have goon too far at a time when the world’s 2^nd largest economy is racing to contain combat from province-backed loans. By end of April, half of the Fed’s $85 bln in purchases would have likely been withdrawn from the market, combined with any spillovers from China’s banks reducing property loans and tightening of mortgage loans. These two dynamics will comprise new reasons to an old seasonal market top.