China: For Global Investors, It’s All About the Currency

China: For Global Investors, It’s All About the Currency

Chinese local interest rates rose substantially late last year, and many bond offerings have been canceled, creating financial strain for some Chinese companies.

How should global investors interpret events in China, and what can they expect for early 2017?

Clearly, investors in China are on edge: Over the past few months, the Chinese yuan’s decline and capital outflows have continued apace, while the People’s Bank of China (PBOC) has taken steps to tighten financial conditions. Adding to the nerves, a little over a year ago, a rate hike similar to the one last month by the Federal Reserve precipitated a downward spiral in the yuan and steep declines in equity and bond markets around the world.

In our view, China is still facing what economists call a “trilemma.” It is proving impossible to achieve three goals simultaneously: a stable or fixed foreign exchange rate, free capital movement and an independent monetary policy. Combining tighter financial conditions with this policy trilemma means that the currency will probably remain an “escape valve.”

In the short term, capital outflows will likely continue. Despite China’s ever-tighter restrictions on currency movements, individuals can still convert the equivalent of US$50,000 into foreign currency annually – and they likely will as the yuan declines further. Over the year, our base case is for the yuan to decline against the U.S. dollar by a mid- to high-single-digit percentage. However, we also think the possibility that the PBOC will allow the yuan to float freely, or at least widen its trading band, has increased.

In recent months, the PBOC has shifted its policy focus from promoting growth to reining in the highly leveraged financial sector. As a result, overall liquidity is likely to remain tight and local interest rates are likely to remain elevated at least through early this year.

Fundamentally, we think higher rates will have a dampening effect on growth over the coming year; our forecast is for a slide in Chinese GDP growth to 6%–6.5% in 2017 from the current 6.7%. More negative headlines, continued stress in the local bond market and disruptive market moves in general will likely feed into the general pressure on growth.

Investment implications on China

Selling in the local Chinese bond market has so far driven yields significantly higher – by about 100 basis points (bps) for government bonds and 200 bps for corporate bonds – but we expect yields to remain both volatile and elevated for some months, and clear buying opportunities may not surface until well into this year.

Amid the disruption in China’s bond market and ongoing capital outflows, the implication for investors is straightforward, in our view. As the Fed raises U.S. interest rates in 2017 (we anticipate two to three increases) and the Chinese yuan continues to decline, we still favor long positions in the U.S. dollar versus the yuan and other emerging Asia currencies.

Luke Spajic leads emerging markets portfolio management in Asia and manages Asian credit portfolios.

Disclosures

Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.