China – New exchange rate mechanism triggers global turbulence

Eurozone – GDP fell slightly short of estimates in 2Q, but quality of recovery looks encouraging

New exchange rate mechanism for yuan

A change in the exchange rate mechanism by the Chinese central bank triggered global turbulence on capital markets this week. The existing mechanism asks market makers to submit quotes for the yuan vs. the dollar every morning to the central bank before market trading commences. From these quotes, the central bank (PBoC) derives the central parity on a daily basis and the exchange rate is allowed to fluctuate by +/- 2% around central parity. It is very likely that the PBoC used its position to influence market maker quotes and with that the central parity. The new mechanism points in that direction, as now market makers are given guidelines as how to determine their morning quote. This should be based on the previous day’s close, supply and demand conditions as well as the exchange rate movements of other major currencies. According to the official statement, central parity had diverged from the market rate. In our view, this is an indication that the PBoC countered a downside on the yuan. So, the new mechanism gave way to existing downward pressure on the yuan.

What followed was 3% depreciation of the yuan during the following three days. On the fourth day, the exchange rate stabilized. Two days before, the central bank had already stated that the new mechanism would increase volatility in the short term but should not lead to persistent depreciation. These comments made it clear that only limited depreciation would take place. On the fourth day, central parity was fixed at a stronger level than the previous day.

Reasons

In its statement, the PBoC reasoned that economic and financial conditions were currently very complex. The looming first rate hike by the US Fed had led to a firming of the dollar, while the euro and yen had weakened. Emerging market and commodities currencies were experiencing downward pressure. The effective exchange rate of the yuan was strong, which was not entirely consistent with market expectations.

We see these statements as clearly indicating that the dollar had pushed the closely tied yuan too high vs. other currencies and the PBoC wanted to counter this development, at least to some extent. Global capital markets feared that this “depreciation” of the exchange rate was an indication that the Chinese economy might be doing worse than expected. However, the most recent data for July does not support this assessment. The IMF supported the new Chinese exchange rate mechanism, as it “allowed market forces to have a greater role in determining the exchange rate”. From this statement, we deduce two things. First, market forces had obviously been less effective previously, which confirms that the PBoC was countering any weakening of the exchange rate. Second, the IMF approval shows that the new mechanism is a step for the yuan towards recognition as an international reserve currency, a status the IMF designates and which the yuan was only recently denied. So the latest action by the PBoC must at least be seen partially in the context of Chinese authorities aiming to get the yuan recognized as an international reserve currency.

Implications

An immediate impact of the change to the new currency mechanism is that the exchange rate of the yuan will become more volatile. At the same time, this increase in volatility will start from a very low level. In recent years a change of 3% in the exchange rate was a yearly movement. Looking ahead, the volatility of the yuan vs. the dollar will not come anywhere close to a free floating currency – the yuan will remain closely tied to the dollar. The recent measured weakening of the yuan is an indication in this direction and also shows that China does not want to trigger competitive devaluations globally. Should a significant change occur in this regard, inflation in developed markets would come under downward pressure, posing new challenges for local central banks. Further, it would endanger the fragile economic recovery. However, we currently see this risk as low.

Currently, we do not expect China to derail the economic upswing in the Eurozone or the US. The Eurozone and the US have already been exposed to weaker demand from China at least since the beginning of the year and have managed relatively well. Growth of Eurozone exports even increased in this period, as demand from other regions compensated for the weakness from China.

The most recent developments could have an impact on US monetary policy. Lower prices of imports from China and lower commodity prices – partly due to concerns over the Chinese economy put downward pressure on the inflation rate. However, since the latest meeting of the FOMC (where indications of a nearing first rate hike were given), the index of commodity prices declined by only 3%. Further, a weakening of the yuan by 3% will have only marginal impact on US inflation. The risk that remains is the severe deterioration of the Chinese economy, which would be felt in the US and around the world. How this risk will be assessed by FOMC members cannot be predicted. The most recent economic indicators from China on retail sales and industrial production showed stable growth. In total we do not think that events so far will change the FOMC’s view materially and continue to expect the first rate hike in September.

GDP fell slightly short of estimates in 2Q, but quality of recovery looks encouraging

GDP increased by 0.3% q/q (+1.2% y/y) in 2Q, thus falling slightly short of market expectations (+0.4% q/q), but delivering a clear signal that the economic recovery is constantly strengthening. Although the components will only be released on September 4, we can already see that the quality of growth is good in some countries. In Germany (+0.4% q/q -> expected: + 0.5% q/q), positive support came mainly from the trade balance. Due to the weaker euro, exports grew more than imports. But, the recovery there is more broad-based. Also, private and public consumption developed positively. A drag came from investments and a pronounced decline in inventories. In France, GDP in 2Q (+/- 0% -> expected: +0.2% q/q) remained unchanged. Whereas stronger exports and stable private consumption were supportive on the upside, investments and a strong decline in inventories dampened on the downside. Changes in inventories usually follow a cyclical pattern and therefore should not continue to dampen GDP calculations. In Italy, 2Q GDP was reported at +0.2% q/q (expected: + 0.3% q/q), but the components have not been yet indicated. All in all, the Eurozone recovery is a touch better than our conservative forecasts (+0.2% q/q and 1.1% y/y) and we confirm our full-year GDP forecast (+1.5% y/y). The ECB is currently monitoring in particular the development of core inflation, which is reflecting domestic price pressure (without energy and food price developments). In 2Q, average core inflation in the Eurozone reached + 0.7% y/y and increased to + 1.0% y/y in July, reflecting the enhancement of economic recovery into 3Q. In our view, bond markets are currently not paying the appropriate attention to the macro data. It seems that concerns about possible dampening effects from China are too big. We therefore have slightly reduced our forecast for the 10Y bund yield for 3Q to 0.9%.