RMB depreciation fears could hurt China’s attraction

Potential escalations in the trade tirade between the US and China has not come at a good time for would-be China investment bulls. Increasingly bellicose language and threats could further weaken the country’s currency and weaken the appeal of its assets with foreign investors who until recently had been eager to acquire them.

For the past several months, global investors have been buying more Chinese bonds, as low interest rate conditions have continued to prevail across much of the developed world.  Foreign investors increased their holdings in its government bonds from 8.1% in April to 8.2% in May, and upscaled their holdings in policy bank bonds from 2.5% to 2.8% over the same time.

Tommy Xie, head of greater China research at OCBC Bank, said the recent increases were likely down to the Bloomberg Barclays Global Aggregate Index beginning to add renminbi-denominated government and policy bank securities on April 1.

But further foreign investor purchases could well stall as the tensions between the US and China continue to mount.

On Saturday (June 8) US treasury secretary Steven Mnuchin told CNBC in an interview that the US could impose 25% tariffs on $300 billion of Chinese imports. Then on Monday (June 10) Trump reportedly threatened to raise tariffs on China if Xi doesn’t meet him at the G20 summit on June 28-29 in Osaka, Japan.

That belligerence is unlikely to gain favour with the Chinese leader. Beijing already didn’t want to be seen backing up an inch in an effort to stoke the nationalistic fervour in the wake of troubles faced by technology giants Huawei and ZTE.

“If the US side insists on escalating the trade friction, we will firmly respond and fight to the end,” a Chinese foreign ministry spokesman told reporters in a daily briefing on Monday.

AN RMB REVISION?

One consequence of these tensions has been on the renminbi; the valuation of China’s currency fell to Rmb6.9337 per dollar on Monday in Shanghai, its weakest level against the greenback since November. The currency pair has since strengthened to around Rmb6.92 as of Thursday, a level last seen in early December of last year.

Economists and investors believe further financial tensions could lead Beijing to let the renminbi’s value to weaken beyond Rmb7 against the US dollar.

“If there is a full blown trade war, then Beijing may want to let go of the support,” for the dollar-renminbi pair, Raymond Chan, chief investment officer Equity Asia Pacific at Allianz Global Investors, told AsianInvestor. “It is wise to continue to signal to the market to hold that level,” he added as a caveat.

The market is already pricing in the renminbi’s value not being supported by the Chinese central bank, said Stephen Innes, managing partner at Vanguard Markets in Singapore. “If the [Chinese] economy tanks [as a result of tariffs], the PBoC won’t have a choice,” he said.

A Bloomberg measure of renminbi risk reversals, or the option market’s measure of puts to shorts, jumped on Monday from already elevated levels, said Bryan Carter, head of emerging markets fixed income, BNP Paribas Asset Management. “Looks like the stars are lining up for a gradual weakening of the yuan," he told AsianInvestor.

And two fund managers in Hong Kong told AsianInvestor the rising cost of hedging their portfolios against currency volatility meant they left this key risk unhedged. The annualised cost of hedging dollar-renminbi risk is up half a percentage point from earlier this year, Bipan Rai, North America head for forex Strategy at CIBC Capital Markets told AsianInvestor. That “makes hedging currency risk a little bit less attractive,” he said.

While short-term funds such as hedge funds would want to hedge such risk from a margin perspective, long-only funds can afford to take a risk and not hedge their currency exposure to the renminbi, the two fund managers said.

FURTHER FALLS

Even a drop to Rmb7 could be too optimistic, according to DWS Group. It estimated last week that the imposition of additional tariffs could cause the yuan to fall to 7.3-7.4 levels against the dollar.

“We now believe China will weaken the RMB in line with trade pressure, using it as a policy tool,” the asset manager formerly known as Deutsche Asset Management said. “The Chinese GDP growth rate won’t fall further, but the currency will.”

This was after mainland traders coming back from a holiday reacted to comments from People’s Bank of China Governor Yi Gang to Bloomberg. Yi said there is no “numerical number” more important than another when asked about defending the 7 level. This was after the more freely traded offshore renminbi dropped to its weakest level against the U.S. dollar since November on Friday (June 7).

Devaluing the renminbi in a controlled manner won’t be easy for China. An attempted controlled devaluation of the renminbi between 2015 and 2016 cost the Chinese central bank $560 billion in reserves to calm frayed nerves, said Lombard Odier.  

This time around, the central bank would be more concerned with the renminbi’s level against a basket of currencies that includes the dollar, euro, yen and 10 other currencies, instead of just the greenback, say analysts.

Either way, the likely further weakening of the renminbi leaves existing potential investors into China with a headache. They need to decide whether to hold onto existing assets, and consider whether to wait until the currency weakens further to make further purchases. That might look a tempting option – but it requires an iron stomach, and a belief that the US and China’s trade disputes won’t spiral into something nastier.

A move beyond Rmb7 would likely result in a risk-off move for global markets, said CIBC’s Rai. Though not likely, such a move “could lead to some investor outflows from China as memories of the August 2015 devaluation are stirred,” he said.