US equity markets feel so 2017, trading close to record highs amid low volatility. But this month is stirring memories of 2015, when the People’s Bank of China (PBoC) changed its currency policy and caused the yuan to devalue 3%, at the time its largest one-off move in more than two decades. In response, the S&P 500 plummeted by 11% peak to trough in just over two weeks, and the VIX index hit 53. Yet this year markets are rising despite the yuan falling by more than 8% since early April.
- This isn't a crisis of capital. In 2015 credibility in Chinese economic policy was weakened by failed attempts to control the aftermath of a collapsed equity market bubble, and the change in currency management policy sparked capital flight: capital flows equivalent to 3% of GDP left the country between August and October. This led to concerns that China would run short of foreign exchange reserves or need to allow a much larger devaluation. This time, tighter capital control and a greater sense of policy consistency mean that capital outflows have totaled less than 1% of GDP in the three months to June. Foreign exchange reserves have remained stable.
- The depreciation is not an overnight surprise. China's economic rebalancing means that its imports have been increasing faster than its exports, such that it now has a current account deficit of 0.2% of GDP. Furthermore, the gap between Chinese and US interest rates has narrowed to just 0.5% today, from 2.6% in January. Both factors confer a weaker currency, so the yuan’s move this year has been understandable, even if the scale of it has been surprising. In 2015, investors were positioned for steady appreciation against the US dollar, so the currency policy shift led to positions unwinding, and sharp revisions to investor expectations for Chinese nominal growth in USD terms.
- A weaker yuan can help offset tariffs. There is a silver lining to a weaker yuan this time. With a weaker exchange rate, Chinese producers can afford to cut prices in USD and maintain margins, or leave prices in CNY unchanged and give US buyers the benefit of the weaker exchange rate to offset the tariffs. This should reduce second-order impacts like supply chain disruption and may help explain the sanguine reaction of US equity markets to escalating tariffs. In 2015, a weaker yuan was seen as a potential cause of global deflation, which is less of a concern today.
All that said, there is still cause for concern and we will continue to monitor the data closely. A worsening in China’s current account or in its economic data, faster capital outflows or signs that the trade dispute may be escalating into disruptive non-tariff measures would all fuel greater concern about the yuan and the broader outlook for risk assets.
Our base case remains for the trade dispute to get worse before it gets better. Against this backdrop, downward pressure on the CNY looks likely to persist. We now forecast USDCNY at 7.0 over three, six and 12 months. While we don’t expect a weaker CNY to destabilize global markets as it did in 2015, given the ongoing escalation in the US-China trade dispute we remain broadly risk neutral from a tactical asset allocation perspective.
The yuan’s sharp slide against the US dollar this year has prompted comparisons with 2015, when an August devaluation sparked turmoil in global equity markets. But this time, tighter capital control and more consistent policy have helped limit fund outflows, while China’s shift from current account surplus to deficit and its shrinking interest rate advantage with the US mean the yuan’s slide is not a surprise. A weaker yuan can also help offset US tariffs. We see the CNY weakening further, but don’t expect this to destabilize global markets.