News & analysis

With the US dollar set to continue weakening as the global economy begins to recover, we expect to see the EM space outperform its G10 peers on the whole after experiencing a deeper sell-off in Q2. The latest fixings by the PBoC confirmed this view and sent bullish signals to market participants.

We expect USDCNY to trade back towards the 7.00 level in the third quarter, but highlight that the road to economic and financial recovery won’t be smooth.

For this reason, we remain cautious in the current environment that the yuan will break below the psychological 7.00 level in the short-run, mainly due to the authorities increased tolerance for a weaker yuan to play a larger part in its countercyclical regime.

While China’s economy was the first to experience lockdown measures due to it being the epicenter of the pandemic, it was also one of the first countries to flatten the curve. After contracting 6.8% in Q1 due to the lockdown measures rolled out nationally, the Chinese economy is set to rebound at a rapid pace in Q2. High frequency data suggest China’s economy will lead the global recovery, with Goldman Sachs’ current activity indicator placing China’s economic growth at 6.7% for Q2 as fiscal and monetary stimulus begins to take effect. However, the latest outbreak in Beijing is a stark reminder for investors that further localised outbreaks are likely as social distancing measures begin to be relaxed. With this in mind we aren’t expecting economic conditions to return to pre-virus levels for some time, but the wave of fiscal and monetary stimulus will vastly improve domestic growth conditions in the interim. With this in mind, we expect USDCNY to trade towards the 7.00 level in Q3, likely testing a break to the downside on pro-cyclical risk appetite. However, risks are tilted to the upside. The main risks come in the form of a wider spread second wave than the base case of localised spikes, along with another phase in the US-China trade war in reaction to the virus, Hong Kong security law and with the upcoming US election.


USDCNY rally to 7.00 level only marks a 0.8% move but is easier said than done in the uncertain global environment



Fiscal stimulus thus far looks to be the main driver of the economic recovery. The government widened the official budget deficit to 3.6% of GDP this year, much higher than the 3% deficit recorded in the wake of the financial crisis, but this overall figure underreports the true level of stimulus. Once accounting for the RMB1trn in coronavirus bonds and RMB3.75trn in special bonds from local governments, the combined deficit rises to 8.2%. Removing the effects of the stabilization fund – a fund used to smooth annual fluctuations in budgets – the deficit widens to 11% of GDP and falls in line with the scale of fiscal response seen in the US and developed market economies.

The data has thus far highlighted that the fiscal firepower is starting to work, but the rebound is focused primarily on the production side of the economy.

Industrial production data showed a sharp rebound in output with value added growth now at 4.4% in that sector for May, while Bloomberg economists estimate that public investment rose for a third consecutive month in May. However, the same vigor in the rebound isn’t seen on the demand side. Retail sales growth was -2.8% YoY in May, up from -7.5% in April but still not in positive territory despite policy responses and reduced containment measures. Fixed asset investment year-to-date still sits in negative territory at -6.3% YoY. The economic recovery in China is front-running the global economy due to the impact of the pandemic occurring at the end of Q1 as opposed to April/ May for Europe and North America, suggesting the slower rebound in global growth will weigh on China’s exports and in turn the domestic recovery.


Demand data lags as recovery is driven by rebound in production


Although overall economic activity has rebounded, with current activity indicators placing the growth at around 6.7% for Q2, the economic rebound is likely to be two-speed. Growth in consumer orientated goods and services is likely to lag when compared with the rebound in production. Further localised outbreaks such as the one seen in Beijing are only going to exacerbate this trend. While the outbreak in the capital city was small and well contained due to the swift actions of authorities, its resulting impact on consumer sentiment underlined how fragile the recovery is. For example, the number of passengers riding the metro had risen to 60-70% of pre-pandemic levels prior to the small outbreak, but has trended down to around 40% since. Anecdotal reports also suggest that Beijing residents are beginning to scale back activities outside of their residencies again, further deteriorating the recovery in consumer demand. However, this won’t be verified until next month’s batch of data. The response by authorities to the outbreak associated with Xinfadi food market provides a template for controlling concentrated spikes in the virus. Authorities readjusted the emergency response level back to II from III (I being the most severe measure out of the four stages), restricted movement in high risk neighborhoods, and required testing for any authorised travel out of the city. Additionally, all schools were temporarily shut, temperature checks were tightened, all taxi services were suspended and flights were partially halted. Given the relative success of the measure in controlling the outbreak and preventing a wider lockdown, it will likely provide the framework for further response measures as localised spikes continue.


Activity proxies in Beijing drop on small outbreak, but remains contained to the region



The PBoC have taken a far more restrained approach to the domestic and global slowdown compared to other major central banks, but its stepped approach runs in line with EM peers. The central bank remains in a dilemma; monetary policy needs to be accommodative to support growth but the risk of a credit bubble remains a primary concern. With this in mind, the central bank has opted to take a more conservative and targeted approach to supporting the economy compared to DM central banks which threw everything they had at the situation. As opposed to substantial balance sheet expansion and lowering rates to the effective lower bound, the PBoC opted instead to lower the required reserve ratio and its associated market driven interest rates with the ultimate goal of releasing capital to SME’s. This is evident in the sharp reduction in the weighted average loan interest rate.


PBoC lowers rates helping the average lending rate decline but in a more conservative way that DM central banks

However, despite its best efforts, a swathe of issuance has sucked liquidity out of the interbank markets and threatens to derail the accommodative stance of monetary policy. Thus far the PBoC has drained north of RMB500bn from the market by not rolling over maturating open market operations, but this has been largely offset by liquidity injections via less conventional channels such as the PBoC’s re-lending and loan-purchase schemes, which will inject around RMB500bn per month in the three-months to September. However, between the time of writing and July, around RMB1.33trn of the central bank’s OMO’s are due to mature, while the issuance of RMB1trn special virus bonds will also soak up liquidity in the coming months. This is evident in the interbank repo market which has seen a spike in interest rates, and in the 10-year government bond market. This will concern monetary policy makers, and as recently as June 17th at a state council meeting Premier Li Keqiang said “the authorities would continue to use the RRR and re-lending rate to maintain ample liquidity” and facilitate corporate lending. This reinforces pressure from above for banks to eat up capital buffers and profit margins to continue the domestic economic recovery. With this in mind, we expect the PBoC to cut reserve rates by up to 75bps in the coming quarter to maintain liquidity in the banking system, while further tweaks in the MLF rate could also be forthcoming.


Surge in issuance and lack of liquidity has caused financial conditions to tighten, paving the way for further monetary loosening by the PBoC



The balance of risks to our bullish outlook on the Chinese yuan and the recovery of the Chinese economy are to the downside and predominantly consist of a larger-than-expected second wave of cases and a resumption of the US-China trade war. Generally speaking, our projection for China’s economy to report an annualised GDP figure in positive territory, likely in the 2-3% range, hinges on the assumption that widespread second waves of the virus will be avoided. Instead, consequent outbreaks will be localised and authorities will be able to control the outbreak in a more targeting manner, leading to containment measures inflicting far less economic damage than in H1 2020. However, the scenario remains fluid, and the recent spike in Beijing and, more worryingly, the southern states of the US highlight the uncertainty around our assumptions. While a significant domestic outbreak would be the greatest risk to China’s economic recovery and the yuan’s retracement to the 7.00 level, further large scale waves in developed economies such as the eurozone and US would derail our outlook through two channels. Firstly, reduced global demand conditions may drag on China’s export market and further containment measures abroad will only exacerbate this. Secondly, the risk appetite channel remains alive and well in the current climate.

Markets are likely to flock to safe haven assets at the first signs of distress in major economies with most fiscal and monetary toolkits emptied back in early Q2.

The second major risk to our outlook comes from the possibility of another phase of the US-China trade war. The White House has previously used China as a political distraction and tensions may reignite with the US elections scheduled in November. Additionally, retaliatory measures from the US Treasury are yet to be announced after China pressed forward with the new Hong Kong security law. The recent communication blunder from White House officials over China’s commitment to the phase one deal and renewing its agricultural purchases may give markets an inkling into the possibility that tensions could reignite in the coming months. The market reaction to Peter Navarro’s comments that a China deal is “over” underlined that the market’s sensitivity to increased trade risk during the economic recovery remains substantial. Should either of these large downside risks materialise, the likelihood of USDCNY trading back towards the 7.00 level in the coming quarter are slim, especially with authorities showing increasing tolerance to using a weaker yuan to support the economy.



Author: Simon Harvey, FX Market Analyst



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