Yuan Devaluation Debate Surfaces as Traders Weigh Next FX Shock

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(Bloomberg) — There is modest yet mounting speculation in financial markets that China will need to take an extreme and highly controversial measure to support its moribund economy — devalue the yuan in a big-bang move.

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Supporters of a sharp currency depreciation say it would allow Beijing boost exports and give the central bank room to cut interest rates. Doubters argue it would only lead to a feedback loop of capital outflows and further yuan declines with the potential to destabilize the global currency market.

Though a minority view, it’s attracting attention as China digs deeper into its toolkit to stimulate an economy and win over investors disappointed by a piecemeal approach to monetary and fiscal support. It’s a controversial option that hasn’t been used since the shock devaluation in 2015, which hammered yuan assets and evolved into a crisis of confidence in China’s ability to control markets.

“A one time meaningful devaluation is a much more effective strategy,” said Bob Elliott, chief executive officer of Unlimited Funds Inc. “The optimal move would be a depreciation to a level where the currency looks cheap and then you hold the line.”

In Elliott’s devaluation scenario the yuan could plunge 10% to 20%.

The People’s Bank of China is caught in a bind as it needs to achieve two conflicting mandates. It has to facilitate an economic recovery by lowering funding costs, but doing so undermines the yuan’s appeal relative to the US dollar and weighs on the currency that’s the cornerstone of financial stability.

Now, that goal is looking even more unrealistic, because the PBOC is fighting against gravity with the yuan being pressured by a rising greenback, capital outflows and concerns over another trade war between the world’s largest two economies.

And holding the currency artificially strong is causing headaches for the PBOC.

The yuan hovers near the weakest it’s allowed to move against the dollar, raising the risk of trading glitches in the spot market. But against a basket of other countries’ exchange rates, it’s close to the strongest in nearly a year, denting China’s already sluggish exports sector.

The PBOC didn’t immediately reply to a fax seeking comment.

“True Currency War”

That has led to the question whether the PBOC should sacrifice currency stability to prioritize growth. To some, the answer is painfully obvious.

“They probably should — to boost exports, help deflation and help domestic growth,” Brad Bechtel, global head of foreign exchange at Jefferies Financial Group Inc., wrote in a note. “But I don’t think they will.”

That’s because the consequences could be enormous.

Domestically, a dramatically weaker yuan can deal a blow to investor confidence, worsen a selloff in stocks, fuel outflows and drive up the cost for local companies to finance foreign-currency debt. It gets more complicated when the PBOC swoops in to slow depreciation with intervention and capital curbs, which can make the market even more volatile due to lack of policy clarity.

Globally, the move may lead to what Bechtel frames as a “true currency war.”

A 5% to 10% slide in the yuan could trigger a 3% to 7% drop in the currencies of export countries in the region, he said. That’s when coordinated intervention may become a reality for nations including Japan, Korea and Indonesia. Central bankers will be forced to hike interest rates and tighten money market liquidity to provide stability — at the expense of local growth, he added.

That risk is becoming increasingly palpable with the likes of yen and won sinking to test multi-decade lows. Earlier this month, South Korea government released a statement saying its finance minister and his Japanese counterpart had “serious concerns” over the recent weakening of their currencies.

For stability reasons, the PBOC will likely resist any large depreciation even in the extreme event of escalating trade tensions with the US, according to Goldman Sachs Group Inc. Beijing will try to prevent a slide beyond 7.7, analysts including Hui Shan wrote in a note.

Substantial Short Position

When the PBOC may make the bold move is anyone’s guess. But the sharp rise in gold and Hong Kong stocks driven by Chinese demand has led to suggestions that some investors are hiding out in safer assets in preparation for a shock in the yuan.

What Bloomberg strategists say:

“Gold trading in China has exploded and stocks of copper have risen sharply prompting speculation that policymakers are on the brink of a yuan devaluation. Even though it’s still a tail-risk, it’s one requiring greater vigilance as the economy becomes increasingly deflationary, redoubling capital outflow pressures.”

— Simon White, macro strategist

For macro trader Edouard de Langlade, shorting the yuan is the most obvious macro trade out there. He coined a China devaluation as the next black swan event in an investor letter sent in July and is now betting the nation’s defense of the currency won’t be sustainable.

“If you do have the reserves but are reluctant to deploy them, it shows weakness as well,” he wrote in a client letter in April. “For that reason, I decided to put on a substantial short yuan position again.”

Some speculate the central bank can time a devaluation before the US elections in November, as that could spare China from retaliation if former President Donald Trump is reelected. Others say it might take place after outflows continue for a few quarters.

So far, China doesn’t seem to be signaling toward a bold move. For months, the PBOC has been using its daily reference rate to keep the yuan steady and state banks are often seen selling dollars to buoy the local currency.

Devaluation or not, a consensus is forming that the only way for the yuan is down. Wall Street banks including JPMorgan Chase & Co., Standard Chartered Plc and Nomura Holdings Inc. say the currency will end the second quarter weaker due to fragile confidence.

And for Elliott, who headed foreign-exchange research at Bridgewater Associates LP in 2015, a devaluation could allow the yuan to trade more in line with fundamentals and put it on a firmer path to international currency status.

“Policymakers think that exchange rate stability is what promotes the use of the yuan as an international currency, he said. “The problem is that it’s manipulated, not the fact that it’s not stable.”

–With assistance from Nishant Kumar.

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