China “playing a dangerous game” with RMB

China is playing a dangerous game allowing its currency to be subject to so much speculation at a time of heightened volatility in global markets, argues Mark Matthews, Asia head of research at Swiss private bank Julius Baer. Uncertainty about the renminbi was a key driver of the 7% fall in mainland stocks on Monday, he said.

China appears to be prioritising the management of interest rates and allowing market forces to influence the renminbi, he suggested, which is “sensible from a theoretical point of view”. But making changes to a currency regime that was considered “sacrosanct” for so long, and at a time when other currencies were falling heavily against the dollar, is risky, said Matthews.

Since Beijing devalued the RMB on August 11 last year by 2% to 6.38 to the dollar, the currency has been on a volatile path, strengthening slightly to 6.31 as of November 2, since when it has weakened to 6.484 as of January 4.

Chinese equity investors, he noted, had been concerned about a lack of support for the renminbi. “There was a lot of volatility last week in the offshore [CNH] market, which now has a spread of 100 basis points over the onshore [CNY] market." This indicates that the market believes the currency will weaken.

The offshore RMB market is less controlled than the onshore one and is seen as an advance indicator of where the currency should go, noted Matthews. Hence, he said, brokers reporting net buying of Hong Kong shares after the Chinese market closed following the drop on Monday afternoon due to the new circuit-breaker mechanism.

Beijing's interest rate policy has been to try to front-run any action by the US Federal Reserve, for fear of subsequent RMB appreciation, said Matthews. But China is playing a dangerous game, because “global fund managers will not touch an asset if they’re uncertain about its base currency”.

This doesn’t fully explain why Chinese stocks would fall so much on the first trading day of the year, said Matthews, but most mainland investors are “retail and emotional and live in a ‘Weibo world’ of instant action”. 

“If they don't know what’s going on, they want to get out fast,” he noted. “So they sold at any price, and the last 2% fall happened in under five minutes, and then the market was shut.”

He thinks the negative sentiment is overdone and that there are plenty of good stories in China that tend to be overlooked. For now, “if the RMB doesn’t collapse, we’ll get through this without much effect on the economy. And if the dollar goes down, a lot of the hysteria about the RMB will disappear.”

The first trading day of January should not be seen as a pointer for markets for the rest of the year, said Matthews. But if markets are lower at the end of the month, statistically “there is a 75% chance that this will be a bad year for equity markets”.

Hong Kong stocks are already oversold, but no market is efficient when it panics, he said, and prices could overshoot even more than they already have. “But if the CNY market doesn’t collapse, we will get through this, just as we did in the summer, with minimal impact to the economy. This stock market and currency uncertainty aren’t enough to disrupt the Asian story of consumption.”