Beyond 7.00, and facing uncertain times

CNY/USD weakness a threat to sentiment

• China’s economy is sluggish. Most data outcomes have been weaker than previous trends; some deteriorated in either July or August. Worse, the gradual improvement in economic activity since April has taken over the heavy lifting from policymakers. Evidently, the tools available, and used by policymakers to revive activity, are rather blunt.
• GDP growth should continue at a reasonable pace. After base effects play out Q2:23, growth may slow again sharply. Beijing is aware of this likely trajectory but will ignore such cyclical considerations during the Party Congress in October. Instead, attention will centre on fleshing out the bigger themes such as Common Prosperity and China’s position on the world stage.  
• Given slower economic growth, depressed consumer and business sentiment, less policy certainty and effectiveness, along with mounting financial risks, it is no surprise that China’s debt and equity markets have experienced net foreign outflows in each of the past six months. Flows are primarily a function of GDP growth differentials and yield spreads, which are moving in a direction unfavourable to inflows. As global financial conditions have tightened, the USD has strengthened to its strongest level in 20 years against most major currencies, buoyed by rising policy rates. Against the CNY, the USD has breached 7.00, now its weakest level since May 2020.
• The path was predictable: not only is China one of the very few isolated countries not currently raising interest rates to fight record levels of inflation, but the People’s Bank of China (PBoC) has taken an accommodative stance since the beginning of the year.
• Looming large are lingering concerns that the CNY/USD’s depreciation may impel a flood of domestic capital outflows from China. True to form then, since breaching 6.80 to the USD last month, the PBoC has been setting the Central Parity Rate stronger than the previous day’s market closing rate.
• Interestingly, looking over the past five years, the evidence in favour of pushing back against some of the competitive losses made against other (depreciating) currencies is scant. In fact, since 2018, the CNY has appreciated against most of its trading partners, but export growth has expanded by an average rate of 11% each month in CNY terms and 12% y/y in USD terms. Quite simply, the strong CNY hasn’t really had any material impact on export growth, nor have cases of a relatively weaker currency boosted the competitiveness of Chinese exports in any manner to materially alter the status quo.
• So, even though at this juncture, Beijing recognizes that export growth faces headwinds, exemplified by the new export sub-components of PMI, and would prefer the trade-weighted value of the currency not to weaken too much in H2:22. On balance, the uncertainty triggered by capital outflows now probably trumps concerns for the export sector.