Developing world financial markets remain the cynosure of the global risk-off trade. Though Chinese financial markets were shut for the last two days of the previous week, the tremors from its money and FX markets continued. On Last Wednesday, the Chinese central bank said reserve ratios would be set at 20 percent of the nominal value of forwards and swap contracts and 50 percent of the nominal value of principal for options. In other words, any person or entity with exposure to onshore Yuan derivatives would have to cough up 20% to 50% of the notional value as upfront margin, denominated in US dollar. I was very surprised to see Yuan, offshore and onshore rates and then Asian currencies rejoice. I found it to be either of the two, (1) another panic driven step riddled with unintended consequences and (2) a clarion call for a large scale devaluation. In either case, there was little sense for the risk on reaction across Asian markets last Wednesday.
The question remains, what is the motive behind such a move? If it is a panic driven move because it sees the risk of a massive increase in outflows in the coming days, then it is bearish for Asian currencies and can trigger even bigger outflows, like how RBI found to its peril, during June-July, 2013. However, if it is a planned move and a pre-emptive move, then it means, that they would like to ring fence the banking system from the effects of a large magnitude move in the Yuan. The question is which way that move is expected to unfold?
Answer is, towards the direction of an asymmetric risk. With a currency, which has spent most of the good part the past 15 years appreciating against the US dollar, it is natural to see speculators have much more long positions than short positions. As a result, PBOC could be using the opportunity to make the banks derivatives positions default-proof by asking for upfront margins. Chinese Yuan needs to be allowed to devalue and such actions make it even more likely.
PBOC may have also triggered a sharp increase in spot demand for US dollars, to be paid as upfront margin. Additionally, exporters with access to offshore Yuan market would look to transfer their hedged offshore to avert the margin, thereby exerting an upward pressure on USD/CNY. Carry traders, which can be significant, may be forced to exit their short positions, thereby causing further upward pressure on the pair. Offshore Yuan has already started to widen its discount over onshore Yuan. Currently the spread between offshore and onshore Yuan has bloated to 11.5 basis points at 6.47 for offshore compared with 6.3550 for onshore rate. Historically, they have moved around each other, it is only since the sharp drop in Yuan last month, these two pairs have become unglued.
Last week, we also got the European Central bank tweak its bond purchase program, without increasing its size but clearly hinting at a possible increase in the future. I found that piece of news extremely disturbing. This was the second instance over the last week, where I initially mis-read the adverse impact of that news. This was now Euro zone’s turn to fire a fresh salvo in the currency war. China can not be helped by fresh round of asset purchase program from ECB or BoJ, they may do more harm than good. China’s stock market has little foreign participation, so a financial market transmission from QE remains limited. At the same time the domestic property market has not much to gain from there, a place where most of the Chinese have parked the lion’s share of their wealth. China needs measures which can help boost its domestic consumption and or create a way for it to import more of global demand. In that scenario, Chinese policy makers have a role to play and externally, US can help. US, unlike Euro zone and Japan, is an exporter of demand. The more US does to stimulate domestic demand, the more help others in the world can have from that process. Instead, if Euro zone and Japan looks to stimulate the economy through QE, it would deflate their currencies more causing these countries to snatch away demand from others. Euro zone and rest of Europe is also the largest market for China, a weaker Euro vis a vis, Yuan, adversely affects China.
Let me summarise the economic drivers in the global economy right now. World over the past decade has come face to face with the problem of excess savings and inadequate productive investment in the real economy. The effect has been following:-
1) Crowding into whatever little economic investments were there, leading to excesses.
2) Asset over-investment, leading to expensive asset markets and even bubbles.
3) Rising unemployment. Excess savings can also be seen as excess supply. Higher supply backed by rising debt coupled with anemic demand, causes prices to fall (deflation) and that leads to producers cutting back on hiring.
Last year, hard assets, unable to defy economic gravity and a resurgent dollar, plus massive supply, went bust. As a result excess savings from the commodity exporters have reduced significantly. On demand side, consumption from them has slackened. Now Asian countries are seeing pressure on their surpluses. Slowly by surely, excess savings pool is getting eroded, a necessary condition for economic rebalancing. However, it is also this erosion of excess savings that is making financial assets vulnerable ( refer to point 2).
Over the short to medium term, there is a possibility that the ongoing risk-off trade may reach a temporary bottom soon, possibly around the US Fed meeting. The choices for the US Fed are three: (1) move ahead with the normalization of interest rates and induce a self-adjusting financial shock on the world financial markets (2) Remove the option of interest hike from the table for the foreseeable future and climb down to neutral ground from where, they can even go expansionary, if the need arises (3) Do nothing but sound hawkish and keep markets in a state of limbo with alternating phases of risk-on and risk-off. I do not know, which path US Fed will choose, because they find themselves boxed and tied.
Over this week, rupee may head towards 67.00 level on spot. In case risk aversion intensifies, then risk of a break above 67.00 could arise in USD/INR spot. If it does move above 67.00 and sustain, then it can aim for 68.00/68.50 levels on spot. Support remains around 65.80/66.10 levels. A clear break down below 65.80, can increase the possibility of a near term top is in place for USD INR. Euro and Yen to find buyers on dips as they are carry currencies. Pound can continue to trade weak till US FOMC. GBP has become more of a play on scenario, where risk of US Fed hike is low and stock markets are on a song. However, when US Fed hike is a serious risk, and there is risk-off, Yen tends to be the best gainer against Rupee, followed closely by the Euro.
Anindya Banerjee is an analyst at Kotak Securities