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Will the Renminbi Continue to Devalue?
August 21, 2015

This article discusses our view on whether the Chinese currency will continue to devalue or not.


Author : iFAST Research



 Will the Renminbi continue to devaluate

Key points:

  1. The new RMB fixing mechanism represents an important move, incorporating the “market supply and demand” element to lead the RMB back to a reasonable level
  2. The RMB exchange rate has become more flexible, which is positive for long-term economic growth and should promote more efficient resource allocation.
  3. The impact of the new currency fixing mechanism on the China market is limited; sectors with high external debts such as property and airlines constitute only approximately 5% of the HSML100 Index’s 2015’s expected earnings.
  4. For the upcoming 1-year period, we expect RMB to depreciate gradually towards RMB 6.6 per US Dollar, under the government’s prudent policy guidance.

On 11 August 2015, PBOC has announced a new currency fixing mechanism, with the RMB exchange rate determined by the price quoted by market makers.  On a daily basis, market makers will provide the quotes to China Foreign Exchange Trading System, with the quotes being set with reference to previous day’s closing rate of the interbank foreign exchange market, demand and supply condition in the foreign exchange rate as well as the exchange rate movement of the major currencies. Over the past 10 years, the PBOC has always been playing the main role in market expectations and stabilizing the RMB exchange rate. Since the beginning of 2015, EM currencies have suffered hefty depreciation due to the divergence of monetary policy measures by major central banks (the Federal Reserve, European Central Bank, Bank of England, etc.). However, the RMB was resilient given that the currency is only allowed to fluctuate within a certain trading band, which did not tally with the market expectation. Thus, the introduction of the new currency fixing mechanism, with the incorporation of the “market supply and demand” element and the widening of the RMB floating band, will allow the RMB exchange rate to better reflect the supply and demand.

We believe that there are three reasons behind the sudden announcement of the new currency fixing mechanism by the PBOC:

  1. Lessening the downward pressure of the nation’s exports on the back of other depreciating currencies.
  2. Liberalising the RMB, taking into consideration the demand of the IMF for the inclusion of RMB into the Special Drawing Right (SDR)
  3. Increase the flexibility of the RMB and the efficiency of resource allocation.

1) Lessening the downward pressure of the nation’s exports

Over the past years, the PBOC has been taking on the important role of leading market expectations and stabilizing RMB exchange rate. Since the beginning of 2015, the divergence of monetary policy measures among major central banks caused most of the EM currencies to depreciate dramatically. However, since the RMB is only allowed to fluctuate within a fixed band, the currency appeared to be relatively more resilient. This did not bode well for China’s exports segment as it reduced the exports competitiveness of the nation.

In the past, China is fully capable of withstanding the negative impacts arising from the appreciation of RMB because economic growth was strong. However, the Chinese economy has not been doing well at this juncture due to challenging internal and external environment. The Chinese economy has witnessed a gradual slowdown, as evidenced by the recent release of sub-par economic data, and this has increased the burden of the nation in maintaining the RMB at its current target level. Thus, the introduction of a new currency fixing mechanism, which is more market-drive, seems to be a reasonable action by the PBOC to bring the RMB back to its fair level. It will also be beneficial for China’s exports segment.

2) Liberalising the RMB, on the consideration of the IMF’s demand for the inclusion of RMB into SDR

The Special Drawing Right (SDR) is an international reserve asset, created by the IMF to supplement official reserves of member countries and serves as the unit of account for the IMF and some other international organizations.  Currently, the SDR basket consists of four main currencies: yen, dollar, the euro and pound. In order for the RMB to be included as part of the SDR, China has to meet the criteria set by the IMF, which are 1) being the major exporter among the member countries and 2) the currency must be freely tradeable. Currently, the market believes that the obstacle hindering the inclusion of the RMB into the SDR basket is that the currency is not freely tradable. As such, the newly announced currency fixing mechanism, which enhances market participation with the currency quote being set based on previous day’s closing price is seen as a positive move that will facilitate the inclusion of the RMB into the SDR basket.

3) Increase flexibility of RMB and better efficiency of resource allocation

Previously, the appreciation of the RMB has led to an economic growth which was more tilted towards imports-oriented industries such as the car manufacturing segment. At this juncture, if RMB depreciates, capital will flow out from the imports-oriented industries towards the exports-oriented industries, which will help to enhance the overall economic structure. Exports-oriented industries such as manufacturing, electrical and electronics and textile are expected to see some improvements in their earnings while car manufacturing industry and other industries that rely on imported inputs and equipment are expected to face downward pressure in terms of their earnings going forward.

Impacts on equity market:

Currently, not much positive impact can be seen from the depreciation of RMB since only a small portion of the HSML100 Index’s constituents are exporters.  These companies’ expected earnings from overseas only constitute approximately 9% of the overall earnings for 2015.

Table 1: Expected earnings for various sectors and percentage of foreign earnings

Sectors

% of market  cap

2015 Earnings Growth (%)

2016 Earnings Growth (%)

2017 Earnings Growth (%)

2015 Expected earnings from overseas (%)

Consumer Staple

2.7

20.3

15.6

14.0

0.8

Consumer Discretionary

3.3

10.7

15.3

12.2

13.4

Financial

47.4

3.4

5.7

7.7

8.7

Energy

17.3

-43.7

44.7

17.9

14.8

Utilities

3.1

8.5

7.9

9.5

3.7

Telecommunication

10.8

2.1

7.5

8.4

0.0

Materials

1.1

-16.5

12.4

8.7

1.5

IT

6.1

28.0

30.5

27.2

14.7

Industrials

7.4

23.3

9.2

11.5

13.1

Health Care

0.9

23.4

21.8

20.3

5.0

Total

100.0

-2.5

11.0

10.2

9.1

Source: Bloomberg, iFAST compilations as of 13 August 2015

However, some of the sectors which have high external debts such as property and airlines will be negatively impacted by the depreciation of the RMB. Most of the local companies do not employ hedging strategy when they issue foreign currency debts (mainly in US Dollar) since the fluctuation of the RMB is relatively low given that it has been trading within a fixed band. The recent one-off depreciation of the RMB has added burden on these companies since they have to fork out more money to repay their foreign currency-denominated debts. According to Standard and Poor’s, more than 20% of the debts of local property developers are external debts. At this juncture, the expected earnings for the property and airline industries make up only around 5% of the market’s overall earnings in 2015. With the tepid earnings contributions from these sectors, the negative impact is likely to be limited unless there is a hefty depreciation of the RMB.

Moving forward

The PBOC has explicitly stated that “the reform of RMB exchange rate formation mechanism will continue to be pushed forward with a market orientation” and emphasized the important role that the market will be playing in the currency exchange determination moving forward. The central bank will also enhance the flexibility of the currency exchange rate movement in both directions and accelerate the development of foreign exchange market going forward.

We expect the PBOC to speed up the process of internationalizing the RMB and the opening up of domestic financial markets. These policy measures will encourage more debt issuances by local companies domestically, which is positive for the development of local bond market.

Will the RMB continue to depreciate? Based on the recent release of sub-par economic data, we believe that it is necessary for the RMB to gradually depreciate to a more reasonable level but we do not see a sharp depreciation. Over the past year, most of the Asian currencies have depreciated against the RMB (see Figure 1). We believe that the RMB will follow its Asian peers on the weakening path, with the expectation that the RMB will depreciate to RMB 6.6 per US Dollar. Given that some of the Chinese companies have external debts and the fact that the RMB has yet to be fully liberalized, policy guidance by PBOC will be prudent. The high foreign reserve held by Chinese government will also mitigate risk of huge depreciation.

Figure 1: Asia: Currency movement against the RMB over the past 1 year (%)

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