The Impact of Moody’s China Downgrade on FX

Key Points:

• China’s sovereign debt rating downgraded.

• Rising risks of an FX intervention from the PBOC.

• Watch for continual Yuan depreciation in the weeks ahead.

The last 24 hours has been a watershed moment for the Chinese economy, as well as the Yuan, as Moody’s have moved to decisively downgrade the countries credit rating from A1 to Aa3. Although markets have reacted with shock, the reality is that macro economists have, for some time, questioned the veracity of China’s economic reporting. Subsequently, it comes as no surprise that Moody’s have finally taken action to confirm a negative outlook for the manufacturing power house. However, it remains to be seen what impact the downgrade will have specifically on the FX markets.

Subsequently, at the time of writing, the USDCNY is currently trading around the 6.8945 mark and the pair has seen plenty of upside momentum which is likely to continue in the coming session. This is a direct effect from the credit downgrade as the market starts to focus on the rising Chinese debt levels and stalling economy. In addition, most economists have suggested that indirect and contingent liabilities will continue to increase and that we are likely to see debt levels around 40% of GDP by 2018. Clearly, this sentiment is likely to be reflected in the FX markets in the coming weeks as traders continue to pile up against the Yuan.

The first impact has largely been to do with restricting capital flows in the aftermath of the credit downgrade. This has seen the PBOC setting stronger daily Yuan fixings to offset some of the capital outflow pressures that have been evident during today’s session. However, this is little respite given the trading pressures around the onshore Yuan and the high demand for the U.S. Dollar. Subsequently, despite firmer fixings, the capital outflows are likely to accelerate in the face of the credit downgrade and this poses a problem for the PBOC in their management of the Yuan.

Subsequently, the Chinese authorities are likely to have to revert to FX interventions in an attempt to help stem the flow of capital from the Asian powerhouse. However, this poses its own difficulties as the nation will need to access their foreign currency reserves to stump up the Yuan’s value and, typically, that can be a losing proposition given the difficulties in holding back the market.

Ultimately, the next few months are likely to be relatively rough for both the onshore and offshore Yuan and a slow but concerted depreciation is likely to be the order of the day. However, be mindful of the risk of FX intervention by the PBOC because, in all likelihood, they are going to be unwilling to give up the battlefield without a solid fight first. Whichever way you look at it, concern about an economic slowdown in China is likely to grow beyond the implications for an FX market, especially if there is a further fall in global trade.