Charlie Awdry, Portfolio Manager for the Chinese Equities strategy, provides his views on the People’s Bank of China’s symbolic move to let the yuan weaken below 7 per U.S. dollar and its significance for investors.
Today the Chinese yuan (CNY) finally broke through to the downside to the psychologically important level of 7 to the U.S. dollar. Seven was a clear line in the sand defended by monetary authorities in Beijing since late 2016. While we are not currency experts, we would not be surprised to see the yuan weaken further now that 7 has finally been breached.
Many will say this breach of 7 is a political decision as part of the U.S.-China trade war, but the economic theory of “the impossible trinity” suggests that over the medium term, policymakers cannot simultaneously control domestic monetary conditions, the cross-border movement of capital and the foreign exchange rate. The move shows that Chinese policymakers are finally giving in to this reality after a period of weak growth and ineffective policy responses. Perhaps it is merely convenient for the CNY to now weaken through 7 under the cover of the trade war?
The question of what this means for Chinese equity markets is a complex one and is made more difficult by the extra volatility brought about by lower trading activity in the Northern Hemisphere’s summer holiday month of August. That it is happening just as the political situation in Hong Kong is becoming more combustible is an extra cause for concern in what are traditionally very emotional Chinese equity markets.
We see the following implications:
- Headwind for Foreign Investors
Chinese equities generally earn CNY profits and have balance sheets dominated by CNY assets, so a weaker CNY is clearly a headwind to returns for overseas investors who think in terms of U.S. dollar (USD), euro or British pound sterling (GBP). Emerging market/Asia Pacific investors can choose between many countries to invest in and, hence, often look to the USD as a base for earnings across countries. A lower CNY will generally lead to lower earnings forecasts for Chinese corporates, a feature that investors tend not to like and that can keep equity markets cheap.
- Offshore Debt Worries
We believe investors should be extremely cautious on the equity of any company with offshore debt financing in USD and Hong Kong dollars. A particular concern to us is property equities because the sector is a very large issuer in the high-yield offshore bond market. Funding CNY is cash-consuming and generating businesses with USD debt is a problem if the CNY falls, as the effective debt load increases and can cause solvency issues. Indeed, over the years, this has traditionally been the Achilles’ heel of corporate emerging markets.
- Credit Quality Issues
As we have held a very cautious view on Chinese bank shares for over a year, this CNY move reinforces our opinion, with the potential for more credit quality issues. Credit quality issues originating from the property sector would not be a surprise, but what is harder to determine are the unintended consequences of this move.
We will be monitoring the situation but it is probably fair to say that, if corporate China has seen the People’s Bank of China (PBOC) defend 7 to the USD for almost three years, those same corporates will have implemented a view that the CNY will not fall below 7 in financial decision-making. While offshore funding is one obvious exposure, we will be watching to see where else risks will emerge. This CNY move can be considered as a policy stimulus to the Chinese economy at a time when economic momentum measured by the Caixin Purchasing Managers’ Index (PMI) survey has been weak. We will also wait to see if the currency move has a significant impact on consumer demand over time.
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