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Renminbi depreciation, an unexpected but welcome move

The depreciation of the Chinese currency took many investors by surprise. And a surprise it was, although not necessarily a negative one, says Victoria Mio.

It came as a surprise and caused some turmoil in the financial markets. The People’s Bank of China (PBOC) has surprised the market on 11 August 2015 by suddenly announcing a 1.8% depreciation of the renminbi (officially CNY, or yuan) reference rate set against the USD. From 11-13 August 2015, the PBOC has depreciated the currency by roughly 3% against the USD.

Victoria Mio, portfolio manager Robeco Chinese Equities, remains sanguine. She sees two main reasons for the currency move. “First, active depreciation of the currency was needed to correct a pent-up exchange rate misalignment. Second, a change in the CNY fixing mechanism to be more market based was necessary to prepare for the CNY’s inclusion into the SDR.” SDR stands for Special Drawing Rights, an international reserve asset created by the IMF in 1969 to supplement its member countries’ official reserves.

Mio thinks this inclusion in the SDR is the main reason for the recent depreciation. “In a report published on the 4 August, the IMF pointed out some technical drawbacks of the CNY, one of them being the lack of a representative exchange rate of the CNY for SDR pricing. It identified fixing as a plausible rate, but said the fixing is not based on actual trade.The fixing is a reference rate that is set daily. And it can deviate by up to 2% from the onshore exchange rate.”

For Chinese policymakers, the inclusion of CNY in SDR is a critical task for 2015. In response, the central bank decided to reform the formulation mechanism of the fixing rate on Tuesday. We expect that the CNY is highly likely included in the IMF’s SDR basket in the coming year.

“We take this as a positive step forward by the central bank to promote further financial reforms. It is positive for the economy in the long term,” she says. “We also would like to point out that since January 2014 the CNY has actually appreciated relative to many other major currencies while it weakened only relative to the USD.”

No currency war

Mio does not think the depreciation will further continue. “We expect the CNY to stabilize at around 3% depreciation and continue to fluctuate in a range of 6.2-6.5 to the US dollar.” A currency war, as some marketwatchers think we might be heading for, is not on the agenda, Mio thinks.

“China has no need and no intention to wage a currency war. It is still in the initial stage of renminbi internationalization. If China joins a competitive devaluation, foreign investors will refrain from accepting and holding CNY. Moreover, in the event of fast and drastic renminbi devaluation, capital flight will accelerate, hurting sentiment. This will ultimately take toll on the capital markets and the real economy. This is the scenario that the policymakers want to avoid.”

Impact on the equity market

Over a longer horizon, a weaker currency may boost the revenue and profits of exporters. But in the short run, sentiment is likely to remain weak in the stock market. The currency depreciation has forced many carry trade positions to unwind, which may cause losses for exporters, says Mio. “Besides the stability of the CNY there is another big question for investors. How is the government is going to exit the intervention in the stock markets? For instance, when to resume IPO, when to allow shorting activities, is likely to be the most important determinant of the A-share markets in the near term.”

She thinks the economy will show an improvement as from the fourth quarter of this year, with a more sustainable performance of the stock market as a result. “In the shorter term we expect the Hong Kong stock market to remain more volatile than the A-share markets. We may see outflows in the offshore stock markets.”

Mio sums up three reasons to remain positive on the MSCI China:

  1. In the economic review politburo meeting chaired by President Xi on 30 July 2015, the leaders indicated that they would pursue an expansionary fiscal policy. We expect stronger fiscal stimulus over the coming months.
  2. It normally takes 6-12 months for monetary policies to show its effect on the real economy. Thus, we expect that the four interest rate cuts and three RRR cuts since November 2014 will bring about a positive improvement in the macro economy in the fourth quarter of 2015.
  3. Currently, MSCI China is trading at 9.2x forward P/E, significantly below its long-term average of 11.5x. When China’s macro and corporate fundamentals show signs of improvement in the fourth quarter, the market will gradually resume the up-trend.

Victoria Mio , August 2015

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