The Tell: A weakening yuan may drag its Asian peers down with it

Slowing economic growth, monetary stimulus measures, and increasingly liberal capital-account controls will likely weaken the Chinese yuan, according to a group of economists and market strategists at Bank of America Merrill Lynch — and the people’s currency would drag its peers in Asia down with it.

In a note to clients released on Monday, the group said that their baseline forecast for the yuan USDCNY, +0.0097%   has it depreciating between 5% and 10% over the next 12 months.

The Japanese yen USDJPY, +0.03%   , new Taiwan dollar USDTWD, -0.1380%   , South Korean won USDKRW, -0.06%  and Malaysian ringgit USDMYR, +0.1736%  are particularly vulnerable because China buys a significant chunk of their exports. Slowing Chinese growth will dampen demand for their goods, hurting their economies and their currencies.

While it’s notoriously difficult to unambiguously define intentional currency manipulation, the group said that any future yuan weakness won’t be the result of intentional policies. “Doing so,” they write, “would trigger competitive devaluation across the region, undermine the stability of China’s financial markets and hurt growth. From a long-term equilibrium perspective, our Compass model finds the CNY fairly valued,” they write.

To keep their currencies competitively valued, Asian central banks will likely respond to a weaker yuan by allowing their currencies to depreciate. Malaysia’s depleted foreign-exchange reserves would make its currency the most vulnerable. The central banks of Korea and Taiwan would be the most likely to intervene, the group said.

The economic slowdown in Chinese growth is the result of structural factors, including a shrinking labor force, diminishing returns on capital, stricter environmental standards and slowing productivity growth, the group said.

Chinese economic growth slowed to 7% in the first quarter, its lowest quarterly rate since 2009 — but still robust relative to other world economies. Official data showed that Chinese consumer-price inflation fell to its lowest level in four months, and producer prices declined for a 39th straight month.

In May, China’s central bank cut its benchmark interest rates for the third time in six months — and more easing measures are expected, the group said.

China is slowly opening its capital account — allowing more money to leave the country — in the hopes of persuading the International Monetary Fund to add the yuan to its Special Drawing Rights basket. The fund, which reviews the basket every five years, is expected to make a decision by the end of the year.

China’s capital and financial account deficit surged to $159 billion in the first quarter, from $97 billion in the fourth quarter, the analysts said.

Luckily, the impact on the U.S. economy will likely be minimal, but commodity-dependent currencies like the Australian dollar and Canadian dollar will likely also be vulnerable, as Chinese demand for their exports also slips.

By

JOSEPH ADINOLFI

 

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