Renminbi Falls. But could this be good news? (4 min read)
It’s an ‘escalation’, a ‘weaponisation’, even a ‘Pandora’s Box of uncertainty’. You can choose from a range of conclusions on China allowing its currency to fall through 7.0, but you can’t escape the fact that everyone so far has been overwhelmingly pessimistic.
Predictably, EM currencies have fallen sharply, mirroring the reactions to earlier tariff hikes, and investors think there is a template here – a weaker RMB is an indication to sell everything. Here’s a controversial take, though: RMB devaluation is a reason to buy, not sell EM currencies.
I think EM debt managers should be adding to risk in local markets, and I submit that this is not the start of a new bear market for EM. It is a position adjustment within a larger lower real rates + spread compression trade. Here are four reasons why:
◦ The latest tariff increase could hurt the US far more compared with previous increments, due to cumulative effects, consumer-heavy product coverage, and a weaker starting point in corporate profitability and CAPEX. The Fed, already teetering, may be pushed into a full-blown easing cycle, and as such, the situation is different from 2018 when the Fed was hiking despite trade uncertainty. It is now cutting because of it.
◦ A more flexible currency regime in China removes the risk of a much larger devaluation in the future. In my previous post , I highlighted that the PBoC was resorting to borrowing USD short-term via state banks in order to maintain a de-facto USD peg. This was unsustainable in the long-term, though, and if continued for a long time would have culminated in a much worse and uncontrolled devaluation. China is experiencing a structural deterioration of its current account due to internal transformation and facing additional headwinds due to tariffs. A weaker currency is the natural response. So why panic?
◦ Well, we should panic, I am told because it’s all going to spiral out of control. I disagree. Chinese authorities have known that a currency adjustment was inevitable, even if the market was complacent, and they have prepared for this. Capital controls remain stringent. The PBoC has a communication strategy. Corporates – even the high-yield property developers – are better hedged on USD debt. Here is a bold call: the demand curve for USDCNY is no longer upward sloping! I expect the adjustment will be well managed, will not be outsized, can be hedged via liquid instruments or North Asian proxies, and so is not an existential threat to EM.
◦ Risk premia are now at levels, where forward-looking returns on EM are very attractive. For fifteen years I have tried to figure out how to time the market. I’ve realized I’m not great at it. But I’ve also picked up that future returns are inversely related to current risk premia. The lower the risk premia, the worse the future returns. The opposite is also true. To illustrate, chart 1 below shows 3-month future performance of a generic EM FX carry trade strategy, during each decile of Morgan Stanley’s composite risk barometer (STGRDI Index on Bloomberg – lower decile = more ‘risk-off’ current conditions). We are sitting in decile 1 now.
Of course, I could be wrong for a number of reasons.
1. The Fed may disappoint expectations in the near-term – a full 25bps cut is already priced for September.
2. There could be idiosyncratic shocks: a hard Brexit, HK protests, or domestic catalysts may muddy the waters further for risk sentiment.
3. It feels a bit early in the unwind cycle. Long EM was a consensus trade until just one week ago, so the unwinding of underwater positions may stretch out longer.
But in the end, while I think the RMB will fall further, I believe the associated fallout in high yielding EM currencies is a fade. I would prefer to fund in a basket of EUR and TWD, rather than USD. This gets you short ‘trade’, and long ‘policy easing’.
Mirza is a macro strategist, specialising in Asian FX and fixed income markets. Mirza is currently working as a desk analyst at Morgan Stanley, prior to which he worked in macro strategy roles at BNP Paribas and Deutsche Bank.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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