Daiwa: Why China's currency might get wobbly

China's currency may be expected to stay reasonably steady, however that's based on misconceptions about the mainland economy, Daiwa stated. One myth was that currency devaluation would not make sense as it would hit China's trustworthiness and jeopardize efforts to internationalize the currency even as it was not likely to boost exports much.

Kevin Lai, Daiwa's primary economic expert for Asia ex-Japan and a yuan bear, stated that any devaluation of the yuan would be aimed at safeguarding the main bank's balance sheet, with efforts to use the currency to increase export competitiveness most likely playing 2nd fiddle.

" Against a backdrop of capital outflows, fixing the yuan to the U.S. dollar at a specific level will require consistent foreign-exchange intervention. Intervention involves selling U.S. dollars in exchange for its own money," Lai said in a note recently. "When a reserve bank redeems its own money, there is a contraction in its monetary base or high-powered money, which is essentially a huge financial tightening."

That would run counter to the mainland's efforts to promote its slowing economy.

" The only way to avoid this tightening is to stop interventions or at least scale them down. That approach immediately causes currency depreciation," Lai said.

The market has actually offered some sign that China's authorities were enabling the currency to weaken, based on individual’s Bank of China's (PBOC) recent daily dollar-yuan fixes. The area currency is allowed to move 2 percent in either direction from the repair level throughout daily trade.

On Tuesday, the PBOC set the dollar-yuan repair at 6.6950, or a five-year low for the Chinese currency, weaker than Monday's fix at 6.6843.

The yuan's weak point against the dollar comes as the mainland is facing a rush of funds heading for the exits.

China suffered almost $700 billion worth of capital flight in 2015, according to the Institute of International Finance. Beijing logged $100 billion per month in typical currency outflow during November, December and January however the speed of outflows had tapered off in more current months, with net foreign exchange sales by commercial banks at $12.5 billion in May, down from $23.7 billion in April and $36.4 billion in March, Reuters reported.

The rise in outflows late in 2015 stimulated market concerns that China's foreign reserves weren't enough to stabilize the currency by buying yuan over the long term. In June, those reserves increased to $3.21 trillion, up $13.4 billion, however that's off a peak of $3.99 trillion in June 2014, according to Reuters.

Regardless of those outflows, many experts expected that a financial crisis was not likely, in part due to the country's high savings rate, however Daiwa's Lai said that was another misconception.

He kept in mind that prior to the Asian Financial Crisis in the late 1990s, lots of countries in the area had high savings rates.

" Long yuan is an over-crowded trade. It took 10 years for dollar streams to go in. Outflows should for that reason lead to a huge domestic financial obligation contraction, unless the currency is let go," he stated.

Lai likewise declared that expectations that China would be safeguarded from a financial obligation crisis because its debt was "purely domestic" were another misconception.

He said that dollar outflows would lead to a contraction of the reserve bank's reserves if the PBOC continued to stabilize the dollar-yuan exchange rate, which would in turn have a contractionary influence on domestic debt.

That's because for every dollar the PBOC receives as an inflow, it prints around 6-7 yuan, depending upon the current currency exchange rate, and then injects the funds into the banking system, where it is "increased" as it is used to create credit, Lai stated. If that dollar drains of the country, it would tighten up domestic liquidity conditions.

China's big bank account surplus of around $80-90 billion a quarter also wasn't most likely to offer much assistance in supporting the currency, Lai said, calling expectations that the surplus would help to fill up foreign-exchange reserves another myth.

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