Macro Monday:Yuan could strengthen with the new “counter-cyclical factor”

Last week, MSCI China edged up 2.3% despite Moody’s downgrading of China.

    The Hang Seng Index hit its highest level since August 2015, when Chinasurprised the market by devaluing the RMB. Property and insurance were thebest performing sectors. Banks staged a nice rally as the pressure fromregulators eased temporarily, as we discussed in the last Macro Monday. TheS&P500 also rose to a record close last week while the Euro Stoxx 50 hit itshighest level since 2015. Last Friday, the CSRC said it would tighten the rulesregarding shareholders and management selling their stocks, in an effort toprotect small investors. China will start releasing the May economic data fromnext week, and we expect growth to keep slowing modestly (our data preview).

    The implications of the "counter-cyclical factor": Last Friday the PBoCannounced a new "counter-cyclical factor" to the current fixing rules. Beforethat, the RMB fixing rate, which is set by the PBoC each morning, wasdetermined by the previous market closing rate and a basket of currencies(i.e. the strength of the US$). Essentially the "counter-cyclical factor" gives thePBoC more discretionary power to influence the fixing rate.

    Some analysts interpreted the move as a way to “curb volatility” or “stabilizethe Yuan”. We think just the opposite. The USD/CNY has been so stable sofar this year that it has become a cause of concern (Fig 37). We put it amongthe three risks in a recent report (link): “(The stable USD/CNY) strengthenedthe belief held by many investors and corporates that the yuan is pegged tothe dollar when the dollar is weak, and it depreciates against the dollar oncethe dollar is strong. With such an expectation, if the dollar strengthens in2H17, depreciation and capital outflow pressures will strike back.”Then why is the USD/CNY so stable? It’s because of the depreciationexpectation. Fundamentals such as rising FX reserves and weak US$ shouldcause the RMB to appreciate. However, the depreciation expectation causedthe RMB to depreciate by pushing the market closing rate to the weak side.

    These two forces balance out and the result is a stable USD/CNY. However,it’s an issue as the Chinese economy is in a good shape in the past fewmonths and the US$ is weak. If these are not enough to make the Yuanstronger, what if China’s economy weakens and/or the US$ strengthens in2H17? No wonder the Yuan’s stability so far this year could be upset byexpectations of worsening depreciation.

    By introducing the new factor, the PBoC now has more discretionary power insetting the daily fixing. The cycle mentioned by the "counter-cyclical factor" isnot the usual economic cycle, but a sentiment cycle. "Counter-cyclical” meansthe use of discretionary power to counter such expectation by setting astronger fixing rate. To do so previously, the PBoC has had to spend FXreserves to influence the closing rate. Now it’s much easier.

    The outlook for the RMB: At the end of last year, we were among the veryfew to forecast that the RMB would appreciate rather than depreciate in 2017,based on our fundamental views such as capital flows and economic growth.

    Fundamentals do move in the direction as we expected. With the addition ofthe new "counter-cyclical factor", we maintain our anti-consensus positiveRMB views.