Ask not whether yuan will fall, but how low it will go

Premier Li Keqiang may believe that “shorting” the Chinese economy is “absurd” but many beg to differ at least when it comes to the yuan, with major banks and hedge funds expecting the currency to continue to fall by varying degrees through the rest of 2016.

On February 3, HSBC analysts raised their “end-2016 USD-CNY forecast to 6.90, from 6.70” characterised by “more and larger USD-CNY upward adjustments followed by policy-induced temporary calm”, a process the bank calls “ease-then-squeeze”.

“Amid strong capital outflows and depreciation expectations in the market”, HSBC argues that China will eschew radical alternatives and seek to follow “a middle path in its pursuit of reforms”.

“This means a slightly accelerated pace of FX flexibility, temporarily aided with some administrative hurdles on capital outflows and other measures to deter excessive speculation,” the bank wrote.

Japan’s Bank of Tokyo-Mitsubishi UFJ (BTMU) also sees some capacity for the yuan to decline in value, expecting it to be at 6.77 to the US dollar by the end of the third quarter of this year before staging a rally into the calendar year end.

BTMU’s analysts argue Chinese domestic economic considerations will lend themselves to a weaker yuan in coming months, noting also that in US dollar terms China’s headline foreign direct investment growth had “turned negative” by the end of last year.

Given that “China in the last five-year plan underperformed its own growth aspirations by so much”, large multi-national corporations might well be re-thinking “the pace at which they are investing into China”, BTMU added. “That implies one next shoe to drop will be fixed investment.”

Being also of the opinion that domestic “consumption is not out of the woods” and flagging the risk of an uptick in unemployment, the Tokyo-headquartered lender foresees some additional yuan depreciation.

Both HSBC and BTMU are thus expecting a measured pace of yuan depreciation. Others agree on the Chinese currency’s direction of travel but feel there is also potential for a more pronounced move.

French bank Societe Generale has a “central scenario (65 per cent probability) [that] envisions USD/CNY reaching 6.80 in 2016 in a largely gradual and controlled manner, but there is a large and growing risk (about 35 per cent) that USD/CNY trades up to 7.50 this year”.

Drawing on International Monetary Fund reserve adequacy research, Societe Generale estimates “if China’s reserves fell to US$2.8 trillion” that “could start to undermine confidence in the [People’s Bank of China’s (PBOC)] ability to resist currency depreciation and manage future balance of payments shocks”.

As part of that “7.50” scenario Societe Generale can envisage a situation where China moves “to a free-float within six months, after burning through a significant amount of FX reserves”.

In this scenario, China “first attempts to resist sharp depreciation with FX interventions, but capital controls fail to suppress the outflows. After bleeding more than US$150 billion per month for two quarters, the PBOC chooses to finish the currency regime reform in one go and let the market decide the exchange rate,” the French bank suggests.

Billionaire investor George Soros made his own position plain at last month’s World Economic Forum in Davos, Switzerland, asserting that “a hard landing for China’s economy is unavoidable” but Soros’ views are arguably mild compared to hedge fund manager Kyle Bass.

Bass, founder of Hayman Capital Management, thinks the idea of a 10 per cent devaluation of the yuan is conservative. “When you look at the size of the imbalance and the size of [the Chinese] economy, it’s going to go 30 or 40 per cent in the end, and it’s going to be the reset for the world,” he said.

Bass’ view may seem extreme but it’s the extent of the eventual yuan depreciation that he expects that is eye-catching, not the idea that the China’s currency will fall.

Some contrarian investors might conclude that with a degree of unanimity among forecasters that the path for the yuan will continue to be lower as 2016 progresses, perhaps the risk-reward is to go against the crowd and position for the China’s currency to rise.

But while there’s always room for a contrarian play, Steven Jen, at London-based hedge fund SLJ Macro, wrote on February 4 that “there are two camps of people in Beijing: those who believe in allowing a fast/quick depreciation in the [yuan] and those who favour a more gradual approach.”

“There is no third camp that believes the [yuan] should not depreciate,” Jen added.

There may be few pandas in the wild, but when it comes to the yuan, there are now a lot of panda bears in the currency market.