Spotlight on the yuan

IT is without a doubt that the US dollar is expected to strengthen further in 2016 now that the Federal Reserve has finally lifted off on US interest rates. Market players are likely to continue playing to the policy divergence theme, which has dominated the investment landscape in 2015.

While the Fed is on a tightening cycle, central banks in Europe and Japan are on the opposite end attempting to boost growth and inflation via massive quantitative easing. However, low or lower oil prices will complicate the path towards achieving the inflation target, not just for the US, but also for Europe and Japan.

Energy prices continue to lean southwards, as the supply glut looks set to worsen over the course of 2016 because both the Opec (Organisation of the Petroleum Exporting Countries) and non-Opec producers are locked in a staring contest. This would necessitate the further use of monetary policies to stoke inflationary pressure, even if their effectiveness is limited by the fact that much of the disinflation or lack of price pressures are due to supply-side factors.

This suggests that the policy gap stands to widen more. The European Central Bank and the Bank of Japan (BOJ) may have to add more stimulus, which would put the euro and Japanese yen under more pressure, against the greenback.

However, there are questions about the limitation of the BOJ's quantitative and qualitative easing (QQE) programme, as the universe of Japanese government bonds to buy becomes saturated. As a result, any additional stimulus may have to be from the fiscal side, which implies a positive view for the Japanese yen in 2016. Indeed, Japan Prime Minister Shinzo Abe proposed a record 2016 budget, worth US$800 billion (S$1.14 trillion), on Christmas Eve.

Meanwhile, the British pound sterling may be assailed by bouts of volatility as we get closer to the UK referendum concerning European Union membership. So far, the so-called "Brexit" has not affected the pound sterling, but the political risks would be negative for the UK economy as well as the exchange rate.

The Chinese yuan will be the currency to watch in 2016. Apart from China being a major engine in the world economy, yuan movements have a knock-on effect on Asian currencies.

China is entering uncharted waters and swamped on many fronts. While Beijing tries to stem capital outflows, they are also piloting a controlled currency depreciation. How much weakness will we see from the yuan is what the world is concerned with.

Yuan depreciation

Barely a year ago, there were hardly any discussions about yuan depreciation. If anything, the yuan was considered undervalued, especially by the advanced economies. Evidently, the hefty trade surpluses and multi-trillion foreign exchange reserves that China holds warrant a much stronger yuan.

To put things in context, the trade-weighted yuan has appreciated some 30 per cent from July 2011 to its peak in August 2015. On several valuation metrics, the yuan is seen as overvalued. It is therefore no coincidence that Chinese exports are trending lower since May 2012. Admittedly, the deterioration in global demand is partly responsible for the trade recession; nonetheless, a considerable appreciation of one's currency is never going to help competitiveness.

Now, there has been a significant shift in market expectations around the yuan and Beijing's policy over the 12 months. The current conditions are not harmonised with the current level of yuan. China is undergoing a structural transformation of its economy, which arguably requires a slower growth momentum during the adjustment period.

Moreover, a series of rate cuts and the economic slowdown have made China a less attractive investment destination. According to the Institute of International Finance (IIF), China posted a record capital outflow of US$225 billion in the third quarter, and is likely to see another US$150 billion flow out of the country in the fourth quarter. IIF projected that China will see a capital outflow of over US$500 billion in 2015.

To complicate matters further, China is constrained by the "impossible trinity", whereby a country cannot simultaneously control the exchange rate, interest rate and capital flows. It can only control two of the three factors at the same time.

As capital outflow intensified, the yuan came under pressure due to falling demand for the local currency. On top of this, the strengthening US dollar piled on more pressure. Surprisingly, the yuan remained stable in the first half of 2015, especially between March and July.

The authorities have intervened substantially to support the yuan. So far, the People's Bank of China (PBOC) has drawn down almost half a trillion dollars to defend the yuan, which is widely viewed as unsustainable. Foreign exchange reserves fell to US$3.4 trillion.

China has to juggle multiple issues while moving ahead with its financial reforms. Keeping the yuan stable is critical to Beijing, although it does not mean that the currency cannot depreciate.

The authorities stunned the markets on Aug 11 with a "one-off" devaluation of the yuan by around 2 per cent, as it switched to a new midpoint fixing mechanism, which is purported to be more market-determined.

While the move wreaked havoc on the financial markets, the yuan quickly stabilised at a new level, thereby soothing any fears, including one relating to the goal of SDR (Special Drawing Right) inclusion.

Moreover, worries over the pain caused to corporates over a sharp devaluation was allayed with the reopening of the Chinese bond market after a six-year hiatus, which offers a way for local companies to reduce risks arising from a mismatch between the exchange rate and foreign debt.

The switch to onshore funding for corporates has reached a record pace, where the domestic bond issuance hit 312.8 billion yuan (S$67.9 billion), according to Dealogic.

Recently, Beijing pegged the yuan (CNY) to a trade-weighted basket of currencies, straying away from the bilateral CNY-USD peg, where it was perceived to be a pre-emptive move ahead of the December Federal Open Market Committee meeting. In theory, the move should contribute to maintaining the yuan stability.

If the PBOC wants to downsize their intervention in the currency market, which is increasingly likely as they continue to liberalise China's capital markets, the path of the least resistance in the onshore and offshore yuan is lower. From that perspective, a weakening trend for yuan seems to be on the cards in 2016.

Certainly, traders will continue to trade the G-10 currencies actively, but a sustained devaluation of the yuan carries serious implications for global economics.

Traders need to assess the pace of yuan depreciation, and determine if there is going to be a counter-reaction from other countries, especially if their exports could be at risk.

• The writer is market strategist, IG Asia

This article was first published on January 27, 2016.
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