China devalues RMB by most in two decades

by **Cals** Thu 13 Aug 2015, 09:52

China devalues RMB by most in two decades
13 Aug 15

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In a surprise move, China’s central bank devalued its tightly controlled currency in an attempt to fend off the slowdown in the world’s second largest economy. This resulted in the biggest one-day drop in the currency’s value since January 1994. Macquarie Equities Research (MER) released a report on 11 August 2015, stating the implications of the cut.

Excerpts of the report can be found below…

2% CNY depreciation due to rule change:
On Monday, the People’s Bank of China (PBoC) announced a revision to its CNY fixing rate setting, which will take into account the previous trading day’s spot close. Monday’s fixing was 6.1162 and the onshore spot close was 6.2097. Therefore, yesterday’s fixing jumped to 6.2298 and the spot rate weakened by 2% to around 6.30.

Hit two birds with one stone:
Why did the PBoC make the change? First, it will lead to a weaker RMB, lending support to export growth. Second, it will make the RMB exchange rate more market-determined, which could help China at the upcoming SDR review in Nov. In the past, one major problem with the RMB exchange rate setting was too much emphasis on its stability against the US$ while neglecting other currencies. In the past 12 months, the RMB appreciated by 23% against the Euro and 17% against the Yen. As a result, so far this year, China’s exports to the EU and Japan are down 4% and 11% yoy. Monday’s change should mitigate the problem.

Does it imply trend depreciation of RMB?
MER does not think so. While MER expects some moderate depreciation of RMB in second half, sizable depreciation (>5%) by year-end is not very likely given concerns on capital outflows. Meanwhile, China’s trade surplus year-to-date doubled from the amount during the same period last year. Therefore, the room for RMB to weaken is fairly limited. If the RMB faces strong depreciation pressure, the PBoC could intervene to stabilize the RMB. In sum, policy makers need to strike a subtle balance between three factors: exports, capital flows and special drawing rights (SDR) reviews.

Domestic demand still key:
For the economy, MER expects a U-shaped recovery in second half, mainly due to better domestic demand, especially in terms of property and infrastructure investment. Meanwhile, capital outflows already stabilized in second quarter. If capital outflows pick up again on a weaker RMB or US rate hike, the PBoC could do two things. First, it could intervene in the currency market. Second, it could cut the reserve requirement ratio (RRR). MER expects one interest rate cut (25bp) and two RRR cuts (100bp) in second half.

Strong bank loan data in July distorted by rescue measures:
New RMB loans in July, were also released on Monday - increased by RMB1.48tn, far exceeding the consensus of RMB625bn. However, the surge was mainly driven by loans to non-bank financial institutions, which soared to RMB886bn in July. This could be attributed to the government’s market rescue efforts, as commercial banks provided funding to China Securities Finance Corp amid the A-share rout. As such, new loans to the real economy (i.e. non-financial corporation and households) were only RMB589bn. Meanwhile, M2 growth jumped to 13.3% yoy in July from 11.8% yoy in June (consensus: 11.6%). Adjusting for rescue measures, M2 growth could be around 12.5% in July.

Debt swap to support government spending:
Another reason for higher M2 growth is debt swap. By the end of July, local governments had issued RMB1.4tn bonds vs. the total RMB2tn debt swap quota announced for this year. Another 1tn debt swap plan could be announced soon. The scheme could help government investment, underpinning MER’s positive outlook for fourth quarter.

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