This week the Chinese yuan (CNY) finally broke through to the downside to the psychologically important level of 7.0 to the US dollar. 7.0 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 7.0 has finally been breached.
Many will say this breach of 7.0 is a political decision as part of the US-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 weaken through 7.0 now under the cover of the trade war?
The question of what this means for Chinese equity markets is a complex one to answer and is made more difficult by the extra market 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:
1. 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 USD, euro or 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.
2. Offshore debt worries
We are extremely cautious on the equity of any company with offshore debt financing in USD and HK 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 Archilles’ heel of corporate emerging markets.
3. Credit quality issues
As we have held a very cautious view on Chinese bank shares for over a year now, this CNY move reinforces our positioning 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 7.0 to the USD for almost three years, those same corporates will have implemented a view that the CNY will not fall below 7.0 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. Given our China equity portfolios have a strong domestic demand focus, we will see if the currency move has a significant impact on consumer demand over time.
Offshore debt: bonds/debt issued outside the home country of the entity guaranteeing the bond.
Credit quality: used to judge the investment quality of a bond/debt. It is represented by a score assigned to a borrower, based on their creditworthiness. An entity issuing investment-grade bonds would typically have a higher credit rating than one issuing high-yield bonds.
Caixin Purchasing Managers' Index: a gauge of manufacturing activity focusing on small and medium-sized companies. Widely used as an indicator of the strength of the Chinese economy.