Warren Dick
3 minute read
12 Jan 2016
1:43 pm

China: hiccup or free fall?

Warren Dick

Just what exactly is going on in China?

The opening salvo from Chinese markets as we entered 2016 was reminiscent of “Black Monday” last year, when on Monday the 24th of August, China’s Shanghai stock exchange lost 8.49% in one day. This sent the rest of the world into a flat panic.

In a similar vein, on two separate trading days last week, the Shanghai exchange lost more than 7%. Circuit breakers were deployed to close the market and prevent further losses, and even after government intervention on Friday, the Shanghai composite closed over 5% lower on Monday.

So, just what exactly is going on?

Two things rattled the markets last week in respect of China. The first was the weak manufacturing data, as measured by the Chinese Purchasing Managers Index, which for December sank to 48.2 from November’s reading of 48.6. Any reading below 50 means the sector is contracting.

The second was the devaluation of the yuan, which – like Black Monday – proceeded to unleash a wave of panic in the market. Any devaluation of the yuan has been interpreted as an implicit statement by Chinese authorities that parts of the economy are struggling and things may be worse than initially thought.

“I find the market response to the devaluation of the yuan ironic,” says Liang Du, portfolio manager of the Prescient China Balanced Fund. “This is, of course, the world’s second largest economy going through a process of capital account liberalisation.”

China’s currency account system is a closed one. Foreign investors can’t simply open a bank account in China and begin buying equities and bonds, as they require approvals and licences to be able to do this. (It’s much easier if you are a foreign direct investor or are wanting to trade with Chinese companies). The Chinese government has sought to address this by liberalising China’s capital accounts in a controlled manner. And that means moving the yuan to a point where it will be freely traded. At present, the yuan is pegged using a trading band to the US dollar, and monetary authorities use China’s massive foreign exchange reserves to keep the currency within the stipulated trading bands.

The shortcomings of this approach became clear as the US dollar began to strengthen almost without exception against all currencies from the middle of 2014. Unlike its neighbours and export competitors – the Japanese Yen, the South Korean won to name a few – Chinese exports didn’t become more competitive as a result of dollar strength because it was pegged to the dollar!

So Chinese authorities realised they had to accommodate this. The events preceding Black Monday last August saw the Chinese devaluing the yuan, as opposed to strengthening it. In the ten years preceding that, the currency had only been strengthened against the dollar, by a cumulative 33%. The change of direction caught everyone by surprise.

“The regulators use two main drivers to determine where the yuan should be trading (against the dollar). They look at where the yuan is currently trading (market forces), and they look at how expensive the yuan is to a basket of currencies (trade-weighted basis). The irony is that global markets want the yuan freely traded, but then gets panicked when the Chinese devalue it in the suggested direction of the market!” says Du.

Du is unfazed by the volatility seen in the equity market. “You have to remember that China has 50 million retail investors, so that provides the volatility. The PMI was no surprise – we know that manufacturing was coming off a very high base, so we still think the opportunities are excellent. And what I do like is that the regulators are always willing to try things – the circuit breaker was a good example. They tried it, it didn’t work, and now they have scrapped it.”

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