With Bitcoin at 3 year highs, China’s renewed efforts to curb declines in its currency are doing little to stop yuan bears who have sent forward devaluation expectations to record highs and options positioning to six-month lows. And judging by Goldman Sachs' outlook - a potential resurgence in Chinese growth fears early next year, but more broadly, a continued bumpy deceleration - things are not getting better anytime soon.
As Bloomberg notes, traders have turned increasingly negative amid tighter liquidity, sending bets for further losses soaring. The gap between forward contracts wagering on the offshore yuan a year from now versus its current level is heading for a record monthly jump...
Just as the extra cost for options to sell the currency against the dollar hit a six-month high relative to prices for contracts to buy.
The currency is facing a triple whammy of accelerating capital outflows, faster U.S. interest-rate increases and concerns over domestic financial markets as liquidity tightens. Strategists say its weakening, set to be the biggest this year in more than two decades, may accelerate as the government restores the annual quota for citizens to convert yuan holdings into foreign exchange. And Goldman Sachs warns, China remains a key risk to watch...
Where we stand now:
Broader concerns about China risk derailing global growth and markets proved somewhat short-lived. After the S&P 500 hit its low for the year on February 11, two days after we published, better economic data and a sense that the Fed would react to global concerns—confirmed by the dovish March FOMC meeting—helped improve market sentiment. Political events in the western hemisphere have since broadly taken center stage in global markets, leaving China concerns in the background. But the reality is that growth—on some level—did take a hit; for example, US GDP growth came in at an anemic 1.1% annualized in 1H2016, owing in part to weakness in the industrial sector and energy-related activity but largely due to tighter financial conditions primarily in the wake of China concerns. China growth itself also remained relatively weak in 1H as measured by the GS China Current Activity Indicator, which declined towards 4% in 1Q and began to climb slowly thereafter.
Stabilizing growth in China has helped push China to the background of investor concerns. In order to stabilize growth and meet official GDP targets, China’s policymakers continued to pursue an ambitious stimulus plan begun in early 2015 that entailed pausing fiscal reforms, sharply cutting interest rates, loosening housing policies, and increasing credit growth. The result: GDP growth looks set to meet the target of 6.5%-7% for 2016, and producer prices are rising after years of deflation.
But policies that re-ignited growth in the short-term just increase concern about the future, especially in terms of credit. We estimate that total credit growth adjusted for muni bond issuance accelerated from 13% yoy in 1Q15 to 17% yoy as of 2Q16, and to 20% yoy when including shadow lending not captured in official statistics. In short, the potential credit problems in China have not receded, and indeed have likely grown given the very fast pace of credit expansion.
Policymakers have taken note of these potentially destabilizing dynamics and have refocused on risk management; indeed, China’s recent Central Economic Work Conference to plan for next year’s economic policy included strong statements on controlling financial risks. Risk management measures employed in recent months include increasing short-term repo rates, reining in off-balance sheet exposures such as wealth management products, and rolling out measures to try to curb home price appreciation. Fiscal policy also seems likely to tighten at least slightly in coming months. But any tightening will likely prove short-lived given that meeting growth targets will remain critical in 2017—a year of leadership transition.
Our RMB view has also become more negative, presenting risk to the US dollar and S&P 500. When we published at the height of market anxiety around China, we were relatively constructive on the RMB, arguing that a large, one-off devaluation was unlikely and envisioning only a “mild” trade-weighted depreciation (against the CFETS basket, the CNY has depreciated 4.5% since then). But capital outflow pressures have remained, particularly in the context of US dollar strength. Despite the government’s official focus on a trade-weighted currency basket, higher $/CNY fixings are still a powerful signal that can easily re-ignite capital flight, as households and firms anticipate a faster pace of depreciation.
Indeed, the PBOC’s FX reserves fell US$69bn to US$3,052bn in November, the largest decline since January. The US election has reinforced these dynamics given the strengthening dollar and potential for trade frictions, motivating tighter restrictions on capital flows. Global markets have so far taken these developments in stride, but the risk of a repeat of related equity market volatility remains, which could impact the pace of Fed tightening and dollar strength.
What to look for in 2017 (and beyond):
A potential resurgence in Chinese growth fears early next year, but more broadly, a continued bumpy deceleration. We expect sequential GDP growth to decelerate into 1Q17 to c.5.5% annualized on recent tightening measures. But we expect a rapid pivot back to stimulus should the growth target look at risk, especially given next year’s leadership transition.
Continued concerns about China credit growth. Although policymakers have introduced tightening measures to reduce the risk of asset price bubbles, China’s reliance on credit growth, which undermines financial stability, remains a key risk.
RMB downside, posing potential risk to the stronger US dollar and global stock markets. We forecast a $/CNY fix of 7.00, 7.15 and 7.30 in 3, 6 and 12 months, respectively, and long $/CNY is one of our 2016 Top Trades. The pace of capital outflows and the evolution of the fix warrant monitoring; in our view, as long as the fix simply offsets dollar strength and capital outflows are contained, global risk appetite should hold up.
China remains a key risk to watch.