Two-way Renminbi Risk?

The CNY has been noticeably weaker in December. After spending several weeks around 6.82-6.83, it weakened towards 6.90, before strengthening slightly at the end of last week when the dollar lost ground to most currencies. In percentage terms, the move is insignificant, but it has sparked speculation about further weakness, perhaps even a devaluation of the CNY.

It would be easy to discount the chatter were it not for the economic backdrop. GDP has slowed significantly in recent months; Q3 GDP came in at 9 percent versus an expectation of 9.7 percent and a Q2 reading of 10.1 percent. Forecasts now call for 2008 GDP growth of 9 percent on a year-on-year basis; however, that number is projected to fall towards 7 percent in 2009, with the very real possibility of only 5 percent growth in the first half of the year. The government has estimated that GDP growth around 8 percent is needed merely to employ the additional labor force that is migrating to the cities from rural areas; numbers below that could swell the ranks of the unemployed and potentially lead to unrest. That puts pressure on the government and the People's Bank of China (PBOC) to do what it takes to maintain GDP growth. In addition, CPI fell to 2.4 percent y/y in November versus an expectation of 3.4 percent, raising the prospect of deflation; currency weakness is one of several ways to fight that. Finally, export growth has collapsed - y/y growth was -17.9 percent in November, down from 15.6 percent in October.

Flows have changed as well; as exports have slowed because of global economic weakness, the supply of dollars and other convertible currencies has been reduced. At the same time, local demand for dollars has soared, in part because of the speculation about further CNY weakness. Even though trade and foreign direct investment (FDI) inflows provide a reserve buffer, it is likely that an attempt by the PBOC to keep the currency stable by supplying dollars to the local market will drain currency reserves by a meaningful amount.

The government has recognized that boosting domestic demand is important at this juncture. Last month's fiscal stimulus package included subsidies designed to boost domestic rural demand for household electronics and durable goods. However, given its size, the export sector is far more critical than domestic demand and clearly a weaker CNY will help boost exports. Even though the CNY has been stable to slightly weaker versus the dollar, it had actually appreciated by over 10 percent on a trade weighted basis over the six-month period ending in November, caused in large part by CNY strength versus the EUR.

In my opinion, while it might suit the PBOC and the government to permit the CNY to weaken further versus the dollar, it will be a slow process and the percentage decline will be modest. Inducing a run on the CNY and having to burn reserves to defend the currency does not make sense. In addition, the Chinese authorities will not want to provoke protectionist sentiment from the incoming Obama administration. Finally, this weakness is unlikely to last long if current broad-based dollar weakness continues. As I say below, I believe the dollar is likely to undershoot most forecasts. If I am right, current spot and forward levels may prove to be an attractive level to hedge CNY payables.

Looking Ahead
As I had expected, the dollar appears to be firmly on a weakening trend (1.3360 versus the EUR when this article was written). However, unlike previous bouts of weakness in recent months, this is not a reflection of reduced risk aversion. Had that been the case, the JPY would have weakened and it has done just the opposite; last Friday's low around 88.50 was the strongest level since 1995. This move is more about slowing repatriation flows and the recognition that the U.S. economy is slowing faster and to a greater degree than earlier forecast. It also reflects the increased likelihood of more quantitative easing by the Fed - in other words, using more than the federal funds rate to impact the economy. By pumping excess liquidity into the system, they increase reserves in the system and force market yields down, which in turn reduces the cost of borrowing. Quantitative easing can reduce a currency's allure, as was the case with the JPY in the 1990s - yields are low and inflation expectations tend to rise. Finally, assuming the administration uses TARP funds to bail out the automakers and avert a crisis as appeared likely at the end of last week, more USD weakness is in store.

Technically, the EUR's break above 1.30-1.31 opens the way for 1.38 and possibly 1.42. Only a break below 1.30 would postpone the trend and it would take a move below 1.25 to reverse it. The EUR has led the way, but virtually all other currencies are rallying, including Asian and Latin American emerging currencies. The laggards include the GBP, which is faced with similar circumstances facing the USD, and many Eastern European currencies, which are plagued by an economic slowdown, falling reserves and ratings downgrades. The weakness across most currencies is consistent with a picture of broad-based USD weakness, as opposed to specific pockets of currency strength as was the case earlier.

Based on my expectations about future economic growth and Federal Reserve policy, I have revised my 2009 year-end projections. Here are some of them: EUR 1.50, GBP 1.75, JPY 95, CAD 1.10, AUD 0.75, CNY 6.7 and INR 48.