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China's softening yuan could block rate cuts

Reuters

HONG KONG (MarketWatch) -- China might not be able to cut interest rates if the yuan weakens further, according to Moody's, which says the end of the strong Chinese currency era could limit Beijing's policy actions.

Markets are coming around to the view that the Chinese currency could now be near its fair value -- instead of moderately undervalued, as maintained by the International Monetary Fund -- according to Moody's analyst Alaistair Chan.

Chan said that while an overvalued yuan was once seen as highly unlikely, this possibility is now being priced into the futures' markets.

Recent data showing that China is experiencing capital outflows as its economy slows could mean an important shift is taking place, he said, noting that the yuan's long upward march against the dollar appears to have ended earlier this year.

"There is growing evidence that the yuan is fairly valued against both the dollar and a basket of major currencies. As such, continued yuan appreciation is no longer a one-way bet, and there is the possibility of a sharp yuan depreciation in the event of a global financial crisis," Chan said.

Any efforts by China to lower interest rates could trigger further capital outflows, undermining efforts to rekindle economic activity.

Inflows drying up

China is already facing a battle to attract new investment.

Data released Thursday showed foreign direct investment of $7.6 billion in July, a drop of 8.7% from a year earlier.

The monthly investment net inflows were the weakest level in two years, signaling what some analysts said was lower foreign confidence in the mainland economy's prospects. Read more on China's shrinking foreign investment flows.

Meanwhile, the yuan has depreciated 0.9% against the U.S. dollar since the start of the year, and the futures markets are pricing in a further 1% drop in the coming 12 months, according to Moody's.

The apparent topping-out is a big change from the 10% annual gains against the dollar since 2005, when adjusting for inflation and changes in wage levels, Chan said.

More recently, the People's Bank of China has been active in propping up the yuan by selling part of its foreign-exchange reserves in an effort to stabilize the currency, analysts believe.

China's balance-of-payments data for the second quarter showed $71.4 billion in net outflows in the capital and financial accounts, exceeding the $59.7 billion surplus in the current account.

Credit Agricole CIB analyst Dariusz Kowalczyk said July data on the foreign-exchange positions of Chinese banks indicated that the central bank had intervened to help prop up the currency during the month, marking the first such actions since April.

He said the interventions were a "very unusual " during a period when China reported a healthy trade surplus.

One explanation, he said, is that the moves may indicate exporters were likely less willing to convert their U.S. dollar holdings into yuan.

Efforts to spark up the domestic stock market could also be seen as part of a strategy by the central government to coax investors to keep their capital in China, according to Chan.

He cited measures such as stringent guidelines on initial public offerings, as well as recently announced delays on new IPOs and lowered trading fees, as efforts to keep up investor interest in Chinese markets.

Reforms unveiled since April, such as increased quotas for foreign investment in the stock market and lifting the ceiling on foreign ownership in securities firms, were also likely attempts to make investing in China more attractive.

"It now seems that the effort was also aimed at stopping investors from pulling money out of China, suggesting that the government is more concerned than it is letting on. Whether liberalization continues or capital controls reappear amid fears of a financial crisis is an open question," said Chan.