Weaker yuan might strengthen China

While the world is fixated today on the ruling against China's claims to the South China Sea at The Hague, the true focus should be on the yuan.

Having weakened nearly 2 percent, to about 6.70 to the dollar, in the two-and-a-half weeks since Brexit, it has thus far noticeably failed to slip out of PBOC's control, in stark contrast to its last slide in January. In fact, today is the half-anniversary (January 12) of the central bank's aggressive intervention in the Hong Kong money markets to stem a full-scale run on the offshore RMB (which had plunged to 6.7618, still its 52-week low as of today), vaulting the benchmark overnight lending rate to over 66 percent.

Tellingly, Chinese stocks are sending a contrarian signal about this latest yuan depreciation: the Shanghai Composite is up nearly 7 percent since the immediate Brexit selloff on Friday, June 24.
This seems to indicate that the weaker yuan is being interpreted not as worsening Chinese economic conditions but as a boost for its beleaguered exporters. More generally, around the world, markets seem to be pricing in the virtual impossibility of a Fed rate hike for the remainder of 2016.

Though the Chinese economy remains fragile and even more so in light of global uncertainty (particularly political uncertainty in the West), there's a growing sense that Beijing is doing its utmost to dictate the pace of devaluation, enabling it to keep an aura of control that confounds China skeptics.

These skeptics tend to underestimate PBOC's determination and ability to manage the RMB's exchange rate tightly enough that it can keep speculators on the margins. Since January, it has inserted itself (via its surrogate state banks) as the single biggest player even in the supposedly open offshore yuan market, and has thereby stemmed nearly $200 billion of outflows through continuous CNH purchasing operations to keep the supply of CNH tight (i.e. short-selling expensive) and any rise in the dollar muted (via constant provision of sell-side liquidity).

This, in turn, has clearly been made possible by massive use of yuan/dollar swaps and forwards to the tune of hundreds of billions of dollars since last summer's turmoil. These contracts, with typical 3-6 month maturities, enable PBOC to pledge ample dollar liquidity in the near future for its constituent banks and thus free them to do its yuan-support bidding in the offshore money markets by offering greenbacks for CNH. At the end of the contract term, the yuan may well have weakened moderately (2-3 percent) and thus compels PBOC to dip into its dollar reserves to offset the shortfall in the rollover of its constituents' derivatives, but the hope is that this will be cushioned somewhat by an improved balance of payments (BOP).

The BOP was clearly strained enormously by the heavy outflows of August 2015-January 2016, but thanks in part to a crackdown on import overinvoicing and bank overpayments for imports since then, the most egregious illegal outflow channels have been significantly constrained. The ongoing anti-corruption crackdown promises to exact a heavier, longer-term toll, too, on particularly large sums leaving the country (whether from wayward officials or haven-seeking private firms and individuals).

Taken together, this means that a moderately weaker (and still gradually weakening) yuan - likely bottoming out at about 7.10 to the dollar in mid-2017 - is a net positive for the Chinese economy. Any decline in dollar reserves caused by this depreciation is likely to be largely offset by a larger current account surplus from boosted exports.

That being said, China can't expect its fellow Asian exporters to stand idly by: they'll also devalue moderately, but in similarly controlled fashion to trace the yuan as a quasi-benchmark. After all, they're all effectively in the same boat of combating overcapacity and deflation, and the last thing everyone needs is competitive, as opposed to collaborative, currency easing.

The US economy, of course, will once more have to provide the anchor of what one hopes will eventually be a rejiggered growth cycle. Rate hikes before the November election are virtually out of the question - not only because of global uncertainty, but also because a Democrat- and establishment-heavy Fed wants as good an economy as possible for Hillary.

Come January, whoever enters the Oval Office will have to unveil an economic blueprint that finally incorporates more comprehensive fiscal stimulus in the form of infrastructure spending: such a boon to Asian exports (and of course, investment in the US) will be the salvation of the global economy in the late 2010s, if only politics would allow it.