Chinese Mayhem

On 2^nd bi-monthly monetary policy, RBI governor Mr. Raghuram Rajan has reiterated his stance on currency – The RBI will continue to monitor currency markets to keep the rupee volatility in check. Back then, a currency analyst might have thought that how much more calm markets does he want? The Indian rupee had been trading in a broad range of 63.30 to 64.30 from last four month. Indian rupee had showed remarkable strength among its peers as major emerging currency markets witnessed sharp depreciation. The key reason for the same was substantially improved macro-economic indicators, mainly improved current account deficit and sustained decline in headline inflation and strong FII and FDI flows Then this dream run of Indian rupee ran-into Chinese Mayhem and rest is history.

Short Background:

Since 2005, China has been following a closely managed foreign exchange regime, where in it sets central parity foreign exchange rate every session and the rate is not allowed to move more than 2% either side. The China being a net exporting country could afford the gradual appreciation of Chinese Yuan against the US dollar. With USD/CNY pair falling from levels of 8.27 in July 2005 to 6.06 in July 2014. 

Case in Point:

After July 2014, global markets witnessed key developments which forced Chinese authorities to devalue Yuan. The commodity markets literally collapsed with major commodities falling nearly 50% due to supply glut and weak global demand.  The sharp decline in commodity prices, led by crude oil, resulted in the lower realization of exports. The Chinese exports declined both value and volume as weak global demand continued to put downward pressure on exports volume.

Second major development was substantial gains of US dollar against major currencies. In times, when major central banks were adopting the ultra-eased monetary policy to support their economies; the US FED started to prepare the markets for US interest rate hike. This diverging monetary policy stance resulted in strengthening of US dollar index, which gained nearly 20% from pre July 2014 levels. Since the Chinese Yuan was more or less pegged with US dollar, it also gained substantially against its trading partners. As Chinese Yuan started losing its competitive advantage the export demand started to shift to competitive economies.

Pulling the Trigger:

The Chinese economy, which has been facing structural slow-down amid the lack of domestic demand, came under further pressure amid the consistent decline in export earnings. The Chinese authorities have been highly proactive on both fiscal and monetary front to fuel the growth. The People Bank of China has cut the benchmark interest rate multiple time and lowering margin requirement to increase the investment activity. On the other hand, the government pledging billions of dollar to stem the free-fall Equity markets.

The Chinese authority finally pulled the trigger after the release of July’s export earnings data, which declined more than 8% on Y-o-Y basis. On 11^th August, People Bank of China announced that it will allow market forces to drive the value of Chinese Yuan. As per the new policy the Chinese intervention will be substantially reduce but intra-day movement will remain in a range of 2% from central rate. Interestingly authorities retained the right to set central parity foreign exchange rate, though it will consider the market forces before deciding the central parity exchange rate.

The Major Asian currencies including rupee, witnessed sharp depreciation in line with Chinese Yuan. The offshore Chinese Yuan (CNH), which does not regulated by China, fell more 6% in just three days; sending ripples in major financial markets. During same period, The USD/INR pair also joined the party and gained nearly 2% to its 23 month high levels of 65.23 levels. Though, there is a little doubt that rupee will continue to take cues from movement in Yuan but one must not forget the state of India’s macro-economic conditions. “Right now the street’s running around with its hair on fire, but the storm always passes and Rupee will stand strong on other side”

Can We Trust China?

The current change in foreign exchange policy is win-win situation for China as it will serve two key purposes. One fall in Chinese Yuan would boost the exports and second, Chinese authority maintained that its new foreign exchange policy regime is a move towards free-float currency, which would lead to inclusion of Yuan among the IMF’s reserve currency.

When a cricket team captain dictate bowler on every single delivery, do you trust him when he says “he allows bowlers to set fielding”. Same is case with China – The China has micro-managed its equity markets it would be pre-mature to trust China, when it says it will allow market forces to drive in currency.

Food for thought - In January, Switzerland National Bank had suddenly removed the EUR/CHF floor rate creating ripples in currency markets, which lead to major defaults across the world. But in hind sight, the SNB took the right decision as ECB announced monetary easing program me, hence it would very difficult to protect the floor prices of EUR/CHF pair.  Similarly, the move by Chinese central bank can also be seen as preparation for US interest rate hike.

Source : Bloomberg, People Bank of China