China shocked global markets out of their summer somnolence on Tuesday when it devalued its currency by almost 2% against the US dollar in an effort to increase its reserve currency status and boost sluggish exports.
In what ranked as the largest one-off depreciation in two decades, the People’s Bank of China (PBOC) adjusted the central parity rate, also known as the daily fixing, by 1.86% from Rmb6.1162 to Rmb6.2298.
The central bank described the change as a “one-time adjustment” and said it wanted the market to play a bigger role determining the currency’s value in future. As such, the PBOC told market makers they should now take account of the previous day’s close, as well as supply and demand dynamics when submitting their quotations for the daily fixing.
Analysts said the PBOC’s previous calculation had been far more opaque and been losing its relevance thanks to an increasing disparity between the actual market rate and the fixing.
Candy Ho, HSBC’s global head of Rmb business development told FinanceAsia that, “this one-off adjustment…is consistent with China's drive towards a more market-driven exchange rate mechanism.”
“With the PBoC also signalling further foreign exchange reforms…it’s clear China is committed to making the Rmb fully convertible sooner rather than later,” she added.
Analysts were almost unanimous in their conclusion that Tuesday’s move was primarily driven by China’s determination to get its currency admitted into the International Monetary Fund’s (IMF) special drawing rights (SDR), a global reserve that currently includes the dollar, euro, yen and pound.
While some analysts pointed out that July’s 8.3% year-on-year decline in exports may have been a factor, most judged that the move was too small to make much of a difference to export growth. Some argued that a third contributory factor is likely to have been the US Federal Reserve impending rate rise, while adding that China’s move now makes the former less likely.
Joining the elite currency club?
In its last review back in 2010, the IMF said the Rmb was still “not judged to be freely usable” and lacked one of the two key criteria for the inclusion into the SDR club.
Last week, an IMF policy report further highlighted the significant amount of preparatory work China still needs to complete ahead of the renminbi’s potential inclusion. This includes extending the Chinese market’s short trading hours and narrowing the divergence between onshore and offshore rates.
Market observers said the adjustment demonstrates Beijing’s commitment to addressing the IMF’s requirements.
“If the PBoC were to continue to keep the renminbi stable against the US dollar, the effect of including it in the SDR would simply be to increase the weighting of the US dollar in the basket – the opposite of what the IMF wants to achieve,” Chen Long of research boutique Gavekal Dragonomics said in a report.
“To justify its inclusion, the renminbi must show greater volatility against the US dollar,” Chen added.
Pressure on debt markets?
However, the unexpected devaluation led to a flight to safety among currency and fixed income investors. At lunchtime in New York on Tuesday, Treasuries had tightened 11bp to 2.11%, while China’s sovereign CDS spreads were 5bp to 10bp weaker.
In the dim sum bond market, Lenovo’s benchmark Rmb4 billion 4.95% 2020 bond also fell more than 0.2 points during the Asian trading day to 101.36, with the yield rising to 4.63%.
“Pressure on the bond markets won’t disappear any time soon because of future devaluation expectations” one Hong Kong-based fixed-income analyst told FinanceAsia. “We believe the offshore bond market will face much greater pressure than the onshore market, as foreign investors are generally bearish on the Rmb.”
Further devaluation pressures were evidenced by 12-month non-deliverable forward rates, which were trading around the 6.6% level on Tuesday, 5.61% lower than the fixing rate.
ANZ economists argued that a more flexible exchange rate mechanism could increase the risk profile of Chinese companies with large dollar liabilities.
“As the US Fed policy rate may rise soon, there is a need for Chinese corporates to hedge against interest rate risk,” they wrote in a note.
According to Credit Suisse, property companies stand to be the biggest losers. The Swiss bank flagged SOHO China as one company with a “huge amount of unhedged forex debt.”
However, trading levels of Chinese dollar denominated bonds were little changed on Tuesday.
For example, Ba1/BB+ rated SOHO China has a 7.125% 2022 bond outstanding. This widened marginally from a mid-price around the 102% level to 102.39% during the Asian trading day.
Conversely, Credit Suisse added that the materials and energy sectors stood to be the biggest beneficiaries. CNOOC's benchmark 3.5% 2025 bond inched tighter from a mid-price of 96.84% to 96.66%.
According to data provider Dealogic, Chinese companies have raised $42.7 billion through dollar-denominated bonds as of May, up 7% from the same period last year.
“However, in the near-term…it will be difficult for the [Chinese] authorities to allow a sharp depreciation of the Rmb,” ANZ economists concluded. “[As] any sharp depreciation of the Rmb will further increase the debt burden of these corporates.”
Additional reporting by Ray Chan.
This story has been corrected to show Lenovo's Rmb bond maturing in 2020 fell 0.2 points