China Curbs Shouldn’t Derail CNY Appreciation

by Win Thin

China took more efforts aimed at “further curbing inflows” with measures designed to “maintain China’s economic and financial security.”  The measures appear to be relatively mild, but like Brazil, China may end up tightening controls further as needed to meet their FX goals.  FX regulator SAFE announced new rules on currency provisioning that will require banks to hold more dollars.  In addition, regulators will reportedly tighten controls on foreign equity investments in China as well as on Chinese overseas special-purpose vehicles.  However, no further details have been given yet.  We do not believe that policies aimed at limiting hot money will have any bearing on China’s policy of allowing gradual yuan appreciation.  Indeed, despite the regulatory changes, the yuan posted its biggest daily gain today since the peg was scrapped in 2005.  China (and most other EM countries) are not so worried about capital inflows per se, but are instead focused on limiting or controlling the wrong (hot) kind of inflows that could become destabilizing when investor sentiment shifts.

These regulatory changes come during the week of China’s monthly data deluge, and with the PBOC hiking the 1-year T-bill yield for the second time in three weeks, markets are bracing for strong data and continued PBOC tightening ahead.  Our base case is for another 75-100 bp of PBOC tightening in this cycle.  The last cycle of 2006-2007 saw 189 bp of total tightening, but inflation was much higher and growth much stronger then.  We believe currency gains are likely to be used to limit imported price pressures too.  During the PBOC hikes in 2006-2007, CNY appreciation was quite significant and saw gains vs. USD of 1.5% in Q2 07, 1.3% in Q3 07, 2.8% in Q4 07, and the peak of 4.2% in Q1 08.  The PBOC used a combination of rate hikes, reserve requirement hikes, and currency strength to help battle rising price pressures in 2006-2007, and that’s what we see happening in 2010-2011 too.

Markets have actually pared back CNY appreciation expectations in recent days, with 12-month NDFs now pricing in 3.2% gain vs. 4% last week.  If anything, our study of the previous tightening cycle suggests that the PBOC will allow greater CNY appreciation than what the market is pricing in currently.  Investors should look to establish long CNY NDF positions on any yuan weakness.  CNY appreciation may be a bit exaggerated this week ahead of the G20 meeting, just as it was exaggerated back in mid-September ahead of US congressional hearings on China.  October China trade data will be released Wednesday, with CPI, PPI, IP, retail sales, and fixed asset investment due out Thursday.  Money and loan data will come out over the next week but no date has been set.