If you follow FX markets closely, here’s a story you’ve read before: investment bank analysts are calling for the Chinese renminbi, or yuan, to break the “crucial” 7 mark versus the dollar. This time it’s Deutsche Bank taking a hop, skip and a jump down a path which has ruined many a market wizard over the past half decade.
A little background first. Rmb7.0 per dollar has long embodied an important psychological level for investors, given the last time the currency weakened past this point in 2008, the global economy was weathering the worst financial crisis since the Great Depression.
Deutsche’s call also takes us back to the winter months of 2015, when fears of a China slowdown roiled global markets following a sharp devaluation over the summer. Readers may have forgotten the infamous “double Wu-Tang” technical formation US markets made in late 2015 and early 2016, but we certainly haven’t:
Then there was 2016’s gradual decline, as the renminbi went from 6.3 to 6.9 by the beginning of 2017. Markets were less fussed, but China bears, such as Hayman Capital’s Kyle Bass, were ready for it to depreciate further.
Pointing to an excessive build up of debt in the system, increasingly low returns on capital and a runaway real estate market, China bears thought a continued depreciation was a forgone conclusion.
It turns out the People’s Republic had other ideas. Tighter controls on capital outflows, announced in November 2016, stemmed the tide. Further measures targeting “irrational” overseas investments in entertainment, sports teams (such as Atletico Madrid) and, of course, property, implemented in August 2017, helped to push the currency higher.
There was, however, a fly in the FX ointment: the Trump administration and its Sino-focused trade policies, which focused not only on exports, but also the value of the renminbi itself.
It’s been over two decades since the US last officially deemed China a currency manipulator in a twice yearly report put together by the Treasury department, but to no one’s surprise, the Trump administration has been quick to accuse Beijing of playing fast and loose with the exchange rate.
In fact, just days after Treasury determined that China was not manipulating its currency in April 2018, President Trump contradicted his own officials and attacked China (and Russia) — via Twitter of course — for “playing the Currency Devaluation game:”
Russia and China are playing the Currency Devaluation game as the U.S. keeps raising interest rates. Not acceptable!
— Donald J. Trump (@realDonaldTrump) April 16, 2018
Of course, China has the wherewithal to intervene as much or as little as it likes in its currency given its heavy hand in the economy. But more often than not in the face of a domestic growth slowdown and an escalating trade war with the US, Chinese policymakers are intervening to prop up, not weaken, the renminbi. They do this by selling foreign reserves and buying renminbi.
As Trump’s accusations mounted and the ongoing trade war took a turn for the worse, the renminbi began to slide again. And a few months after a moment in late 2018 when it looked like a 7-handle might be possible, it looks like the currency is once again heading for a ceiling that so far has proven impassable.
Here’s the chart over the past five years:
So what do the wonks at Deutsche reckon the catalyst is this time? Well, here’s their reasoning (emphasis ours):
Based on our recent trip to Beijing, we feel policymakers will be more agreeable to CNY depreciation now. First, Chinese policymakers appear more prepared for trade frictions and proactive in managing the growth fallout; growth is in better shape than last year, and the economy has responded to earlier stimulus. In 2018, when domestic data was poorer and there were fears of growth falling below 6.0%, a break above 7.00 was less acceptable, given risks of a negative feedback loop to an already weak economy. With the trade war likely to be protracted, finding ways of keeping domestic growth supported should be a priority for policymakers. This is likely to require looser monetary policy, which could come at the cost of a weaker currency. Authorities should be more willing to bear that cost this time.
Second, concerns over the “externalities” to currency weakness — hot money outflows and corporate stress seem more limited this time. Regulators appear more confident that years of regulatory measures will keep hot money outflows manageable. Corporates are now better hedged against FX weakness, and industrial profitability has been stronger, reducing concerns about the corporate balance sheet impact from a weaker CNY. Importantly, we have noted that CNY has been reacting predictably to the imposition of tariffs over the past year, with the move higher in USD/CNY proportional to the weighted average tariff being borne by Chinese exports to the US. The latest increase in tariffs to 25% on $200bn of goods is consistent with USD/CNY close to 7.10. If Trump proceeds with tariffs on $300bn, even at an initial 10% rate, this could take USD/CNY to 7.40.
So two interlinked reasons: stimulus from policymakers, in part due to the trade war putting pressure on growth.
The latter argument is accompanied by this excellent chart, that matches the weighted average of Trumps tariffs versus the renminbi:
And then there’s the question of corporate balance sheets. While a weakening renminbi might be okay for relatively debt-light technology companies like Tencent and Alibaba, it’s not so simple for the systemic real estate businesses.
Throw your mind back to this FT article from late April, on the dollar-denominated debt of the real estate giants, such as FT Alphaville favourite Evergrande, who had raised $6.6bn in debt this year, as of mid-April.
This chart for the whole market tells its own story;
Whether these companies will be happy with a weaker RMB remains to be seen. A UBS note, out Thursday, in particular, was dour on China’s real estate market going forward:
Real estate fundamentals are weakening amid decelerating economic growth, but the government dialled back its deleveraging efforts and is enabling more relaxed monetary conditions . . .[and] Fully let properties in liquid markets are being exchanged at yields below financing costs. This poses a greater risk, as room for capital appreciation is limited given the sluggish economic outlook. Investors should be aware of city-specific policies.
Higher dollar financing costs for the providers of these assets, who also hold a lot of them on balance sheet as investment properties, probably won’t be of much help with yields already slipping below financing costs.
But it feels like the same old story with China. Investors point to deteriorating fundamentals but then, without fail, the can manages to get kicked down the road. Somehow. However with Trump, rather than local authorities, now available to blame for the economic slowdown, perhaps there’s never been a more opportune time for the People’s Republic to let the renminbi slip past 7.
Just don’t tell Kyle Bass; he exited his trade last week.