Why the Pound's Rally vs. China's Yuan is Likely to Continue

- PBOC lifts RMB after attempt to soothe markets over recent losses.

- Says will keep currency at "reasonable and balanced level" in future.

- Analysts are split on whether the PBOC itself is behind recent weakness.

© GovernmentZA, image Reproduced Under CC Licensing

The decline in China's Yuan eased somewhat Tuesday in response to an intervention by People's Bank of China (PBOC) officials geared toward placating markets over recent losses for offshore exchange rates, although analysts are still warning of further weakness ahead.

The intervention comes within the context of an ongoing rout of Chinese stocks - the Shanghai Composite Index is near a 28-month low - while the CNY also continues a sharp decline with USD/CNY now trading above 6.70, the highest level since August 2017.

The GBP/CNY meanwhile trades at a two-month high at 8.7701 in sympathy with the broader decline in the Chinese currency.

Fears over how the Chinese economy will fare in a so-called trade war with the United States have seen the Renmimbi depreciate by around 4% against the US Dollar and Euro as well as by 3% against the Pound, Japanese Yen and Swiss Franc during the last month.

The Chinese currency had risen by 6% for 2018 during the period to the middle of April, when the US Dollar first began to strengthen, but is now relatively unchanged against all major currencies barring the Yen and Dollar following a sharp depreciation in late May and June.

Given the PBOC has a history of manipulating its exchange rates, much has been made of the recent weakness although central bank officials stepped in on Tuesday, making their intentions known and attempted to assuage concerns over a possible state-led devaluation. 

"We have the fundamentals, capabilities and confidence in keeping the yuan's exchange rate basically stable at a reasonable and balanced level," says Pan Gongsheng, deputy head of the People's Bank of China, at a forum in Hong Kong Tuesday.

These comments were echoed by PBOC governor Yi Gang in an interview with the China Securities Journal, which is sponsored by state news agency Xinhua, on Wednesday and gave way to a relief rally by the Chinese currency.

A Weapon in the Trade War

A weaker currency can make a nation's export goods cheaper for overseas customers to buy, making for an improved competitive position.

In the current context of a global trade war, where tariffs are being imposed by the US on its own imports of Chinese goods, currency devaluation can help offset the impact that tariffs have on international demand so markets are eyeing the recent fall in the Renmimbi with suspicion.

"There is no sign of China intervening to halt the CNY decline as CNH offshore money market rates have dropped. Normally, China uses higher CNH money market rates to stem depreciation pressure. The lack of intervention suggests the Chinese government is allowing the CNY to slide possibly as part of the trade war with the US. We continue to see risk of further CNY weakness in the short term," says Allan von Mehren, Chief analyst with Danske Bank in Helsinki.

(Note: CNH is offshore Yuan which is freely traded, CNY is onshore Yuan which is controlled by the central bank. The official name of the currency is Renminbi, the unit of account is the Yuan).

Trade war concerns are darkening an already-dim outlook for the economy according to Zhou but, with the PBOC now likely to use interest rate cuts and other measures to stimulate the economy during the months ahead, the outlook for the currency is growing even darker still.

"Our view is that a significant portion of the recent RMB decline has been encouraged by the PBoC. The fact that Yi is now talking about ‘market volatility’ and ‘USD strength’ as key drivers for the move lower in the RMB does nothing but support this argument," says Stephen Gallo, European head of FX strategy at BMO Capital Markets. "All the RMB has really been doing lately is catching up with the rest of the local market space, and that is a shield for China to hide behind as it continues to adapt to the twists and turns offered by the Trump White House."

Gallo observes that the Renmimbi's depreciation has slowed in recent days and that it went into reverse on Tuesday.

Such a steady decline indicates the currency has not yet reached levels likely to be a concern for the PBOC, as well as that Chinese and international firms are not yet panicking about the economy or the outlook for the currency.

This is best demonstrated by the forward curve, which Gallo describes as relatively flat. If markets were truly concerned about a possible Renmimbi devaluation or an economic crunch in China then the forward prices of Renmimbi would be higher than the exchange rates prevailing Tuesday.

Nonentheless, the BMO team warn of further losses for China's currency in the months ahead. 

"This suggests to us that the move up in USD/CNH has further to run despite indications today that PBoC is looking to slow the pace of RMB depreciation. My preference here is to continue looking for opportunities to get long of the 3M USD/CNH forward in expectation of a move towards the 6.80 area heading further into the summer," Gallo writes, in a briefing Tuesday.

A Simpler Explanation

While Gallo and the BMO team are eyeing the PBOC suspiciously, as well as forecasting further losses for the Renmimbi, others say the reasons behind currency's fall are a lot more simple.

"Rapid CNY depreciation has triggered concerns among our clients whether the Chinese authorities could use the currency as a weapon amid rising trade tensions. We don’t think so," says Hao Zhou, an analyst at Commerzbank. 

Commerzbank's Zhou says the recent fall is likely the result of deteriorating economic fundamentals, given that the tariff fight with the US is coming at a time when Chinese economic growth had been expected to decelerate anyway.

President Donald Trump has been pursuing restrictive legislation to govern Chinese investments into the United States and recently ordered that a range of tariffs be levied against imports of more than $250 billion in American imports of Chinese goods. The latest levies come into force on July 06.

The White House is seen as using "protectionist" trade policies in an attempt to reduce the US trade deficit, citing it as a sign of malpractice by other countries in the international trade arena and evidence that action is needed by the White House. The measures against China come despite that Trump himself said back in May that China had agreed to buy a significant amount of US agricultural products to bring the deficit down.

China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!

— Donald J. Trump (@realDonaldTrump) May 21, 2018

The White House has also levied new tariffs on all imports of steel and aluminium from China, Canada, Mexico and the European Union. The moves so far have drawn retaliation and threats of even further reciprocal measures from the Chinese.

This all comes on top of earlier White House tariffs on imports of steel and aluminium into the United States from across the globe, including the European Union. The EU has since responded with its own levies on US motorcycles, jeans and whiskey, drawing threats of even more tariffs from the White House, this time targeting the mighty European automotive sector.

Fears are that a tit-for-tat tariff fight between the world's largest economies will quickly descend into an all out "trade war" and that this will dent economic growth in all countries it touches. That could stymy the Federal Reserve from raising its interest rate further while also denting the odds that other central banks will be able to raise their rates any time soon, with far reaching implications for exchange rates.

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