New deflation scare risk in Chinese devaluation moves

Thursday 13th August 2015

China's move to lower the value of its currency looks likely to further depress weak global prices for a range of commonly traded commodities, says economist Andrew Hunt of Hunt Economics.

Hunt, who is an adviser to a range of global financial institutions and investment houses, including in New Zealand, says this week's surprise action by the People's Bank of China to change the way it calculates the daily 'fix' for the renminbi (RMB), or yuan as it is also commonly known, may also follow a bout of foreign debt reduction by Chinese borrowers over recent months.

"We had been expecting such a move to occur once the country's external borrowers had managed to repay some more of their existing foreign liabilities," said Hunt in a note circulated after international markets were surprised by the fact that Tuesday's initial depreciation, characterised as a 'one-off' adjustment by the PBOC, led to a second day of RMB depreciation on Wednesday and sparked fears of a new 'currency war' in which major economies seek to weaken their exchange rates to boost export competitiveness.

Tuesday's announcements prompted a fall of about 1.9 percent in the value of the RMB against the US dollar and it fell another 1.6 percent yesterday in a move that traders said proved the Chinese authorities are allowing global markets to have a greater hand in fixing the value of the RMB, despite it remaining subject to a 'managed float' regime.

"They are trying to make their currency more market driven as part of this whole process of freeing up the government controls on the RMB so that eventually the RMB can take its place amongst the world's major trading and reserve currencies," said Peter Cavanaugh, an adviser at Bancorp Treasury Services in an overnight note to clients, noting that Chinese authorities appeared to intervene late in trading on Wednesday to "prop up the RMB."

"It would be a signal that this is simply a technical adjustment, not a policy move. I think they misread the market response and were shocked with the severity of the market response. If they were going to set today's (Thursday's) rate at close to market close then they would have three days of devaluation and risk going down a spiral."

However, Hunt said the case for a weaker RMB was obvious, with "a clear recession" in the Chinese industrial sector and a "clearly over-valued" RMB.

"We can assume that there will be further weakness in the RMB ahead. The weakness in the RMB must also be considered as being simply part of the general move towards currency depreciations that has been favoured by Japan, Europe and more recently the rest of Asia that has led to a sharp fall in world trade prices over the course of this year."

This had been one of the causes of deflation in many economies, "and we would expect this deflationary/profit sapping cycle to continue now that China has entered the game. Everyone's exporters will need their governments to respond," Hunt said.

Currencies sensitive to commodity cycles, including the Australian and New Zealand dollars, were likely to show ongoing weakness and "China's actions will presumably lead to more reported weakness in US retail sales."

Among the indicators of Chinese economic weakness were a sharp spike in labour costs relative to export prices and revenues and it was likely that Chinese producers are "sitting on an elevated level of inventories at present."

"Japan and others have used their currencies as an 'inventory disposal tool'. Could China now be following suit?" Hunt asked.

"With regard to the timing of the weaker RMB, we do wonder if the news that the Hong Kong banking system has significantly reduced its implied exposure to the RMB over the last year may be significant. Judging by this data, China may have repaid many of the foreign liabilities that it incurred in the previous few years. With these liabilities partially discharged, China will have had more room to manouevre with its currency," said Hunt.

BusinessDesk.co.nz

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