EM FX Weekly: The CNY slide

John Hardy

Head of FX Strategy, Saxo Bank Group
John Hardy joined Saxo in 2002 and has been Head of FX Strategy since October 2007. He focuses on delivering strategies and analyses in the currency market as defined by fundamentals, changes in macroeconomic themes, and technical developments.

China has seized the market’s attention by allowing a sharp slide in the renminbi over the past two weeks, as investors ponder whether this is merely a signal that China is no longer interested in seeing its currency strengthen versus the official reference basket or if it is “weaponising” the renminbi in the trade showdown with the US. Elsewhere, MXN is buoyant ahead of this weekend’s presidential election and despite the prospects of a left populist Obrador winning with a strong mandate. 

EM developments over the last week

This week’s currency highlight briefs:

CNY: the sudden weakening of the Chinese renminbi this week has grabbed the market’s attention as it represents a sharp change of course from the prior regime of strength (before this recent move, the CNY was only gently weaker versus a very strong USD, so it was actually quite strong in broad terms). Speculation is swirling to the degree that China is mobilising exchange rate policy as a tool in the showdown over trade with Washington. From here it is worth closely watching the USDCNY for whether China intends to weaken the CNY further – a further sharp devaluation would be a very negative signal for emerging markets, particularly countries exporting into China and commodities exporters (BRL, CLP and PEN). This is not the scenario we anticipate, but the CNY is fundamentally overvalued on a real effective basis and this latest move is unsettling regardless.

Chart: USDCNH and official CFETS reference basket: So far, while the USDCNH move (the offshore CNH tracking CNY much more closely than back during the 2015-16 drama) has been very sharp relative to the prior action, the actual USDCNH level is merely back to the area of stability around 6.60 from late last year. So the temperature is raised significantly if it is allowed to move back into the 6.70-7.00 zone and concern would likely mount exponentially above 7.00. 

Unfortunately, the reference basket (CNY is weak when line heads lower) is only updated once a week and the latest data point is due shortly, but the weakening here is still far less pronounced, providing more support that China simply wants to slow or stop the general appreciation of the renminbi in broad terms. It would take a considerable further weakening in the reference basket to suggest a real devaluation move is afoot. What is China’s intent? We don’t know, but we suspect the move will slow from here, as a further rapid weakening could only act against China’s general interest in maintaining stability and avoiding capital flight pressures from domestic savers, even with strict capital controls are in effect.

Source: Saxo Bank

Source: Bloomberg

TRY: the lira has managed further stability and even strength locally after Erdogan’s victory in the June 24 election. Overtures from US President Trump have likely helped at the margin. But the structural situation remains fragile for Turkey, and the central bank has burned through more of Turkey’s reserves, which amount to only around $80 billion as of last week, down from around $90 billion at the beginning of the year. Erdogan will be hard pressed to make good on promises for huge infrastructure investments made during the campaign and the market will likely turn viciously on TRY once again on the least hint that he will interfere with central bank policy.

MXN: the presidential election is up over the weekend and left populist Obrador appears on the verge of a strong mandate. Obrador appears mostly focused on the domestic agenda and has avoided making any strong comments on trade issues or Trump and credit spreads have improved. Post election, the focus will quickly shift back to the risks of unaffordable fiscal excess from a populist governor which has vowed spending for his voters and Mexico doesn’t have the greatest of starting points as fiscal dynamics worsened suddenly in the first quarter of this year to nearly 3% of GDP after holding near 1% last year, likely on election-motivated spending.

CLP: A small note on Chile. Recently, many ex-Asia EMs have seen their credit spreads with the US tighten or at least fail to worsen notably. Chile still has a strong credit rating, but the spread on its 2042 USD bonds is poised at the cycle high this week vs. its US counterpart. Also this week, copper prices tested below the three dollars/lb. level that looks pivotal on the longer term chart. CLP is likewise pushing. We have highlighted Chile’s growing structural imbalances before and highlight again here the risk of underperformance if the copper price falls further and the risk that the market reprices the country’s creditworthiness.

Chart: Global Risk Index – risk conditions worsen further

Our broad Global Risk indicator is showing a general worsening trend, though as of this writing, a number of EMs (especially Mexico, but also Turkey) saw their credit spreads improving after a prior one-way slide, with spreads elsewhere worsened again – notably in Asia and likely linked to the CNY weakening over the last couple of weeks. The worsening of our risk indicator this time around was driven to a greater degree than in has been in many weeks by a rise in market volatility in both equity and FX markets. Corporate credit metrics have also weakened to the worst levels since the 2014.

Source: Saxo Bank

EM currency outlook: CNY and US data in the spotlight next week

There is nothing in the current environment that alleviates our general concern level for global risk and concerns have only risen on this latest move in Chinese currency, though we doubt that China is doing this in a warm up move aimed at devaluing its currency. Two things to focus on for the coming week: first has this latest CNY move has run its course (or rightly stated, whether China decides to stop it). Second, how strong will US data come in through the end-of-the-week jobs report. We think the Fed is more hawkish than the market has priced should the economy continue to perform in line with expectations. Fed governor Powell has raised the profile of the Fed’s so-called third mandate: “financial stability” in many of his recent comments, as rather astutely discussed by one observer . We will continue to look for value should an all out risk deleveraging move materialise or if conditions improve more than we expect.

EM currency performance: Recent and longer term, carry adjusted

Chart: the weekly spot and 1-month carry-adjusted EM FX returns vs. USD. Some considerable mean reversion in places, as MXN and TRY have been short-term strong performers, while the ZAR has been the weakest currency again over the last week, likely due to the weakness in precious metals and due the hefty percentage of Asian destinations for its exports. We discuss the weak CLP as well above. Finally, note the weak performance over the last month of CNH and China-linked economies like Indonesia (despite very robust central bank response to weak currency) and Thailand and Korea.

Source: Saxo Bank

Chart: 3-month and 12-month carry-adjusted EM FX returns vs. USD

The only currencies higher versus the USD on a carry adjusted basis over the last year are a couple of commodities exporters (COP due to oil and PEN due to carry combined with an apparent managed peg regime) and the Chinese renminbi and currencies closely associated with China (TWD, THB, KRW, MYR and SGD). With China shifting away from its strong FX regime, these currencies could quickly join their other EM peers in the negative column versus the US dollar as the Fed tightens further and our global risk indicator points south. While exporters can look stable due to their external surpluses, the growth risks for their economies in the event of weakening growth in their destination markets can be multiplied back at the point of origin. So the trade war risk is easily as pronounced for exporters.

Source: Saxo Bank

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