Poorly communicated and executed

The biggest driver in the currency market last week was not monetary policy divergence but rather risk aversion caused by outright fear. Risk aversion went into high gear on worries over a China slowdown, sheer panic in the Chinese stock market, a sharp drop in the Chinese Yuan adding to current disinflationary macro environment, and uncertainty around further FOMC interest rate hikes in 2016. The global ramifications of all this led to stocks being sold around the world causing carry trades to be unwound thereby making the Japanese Yen the top performer. In fact, it was the biggest weekly gain in the Yen against the USD since August 2013.  The media always seems to characterise the unwinding of the Yen carry trade as a safe haven move, which it is not. The carry trades is a strategy in which an investor borrows funds in a currency with a relatively low interest rate such as the Yen and Euro, due to its current negative rates, and the converting and investing of those funds into a currency yielding a higher interest such as the AUD and NZD. The big moves in the currency market last week was due to the unwinding of the carry trade which caused the AUD and NZD to be sold so that loans in the Yen and Euro could be paid back.
 The week started with news that Saudi Arabia executed a prominent Shiite Muslim cleric during a mass execution of 47 people. This ignited a regional rivalry between Iran and Riyadh injecting volatility into oil trading. This was quickly followed by the worse than expected Caixin  Manufacturing PMI for China falling to 48.2 from 48.6 in November, which was down for the 10th straight month.  This revived the China slowdown fears causing stock markets across Asia to fall. Circuit breakers kicked in after sharp selloffs but by the end of Monday the Shanghai Composite fell nearly 7% and the Shenzhen Composite lost 8.25%. This in turn ignited fears of greater Chinese stock market losses as investors feared that the ban on sales by larger investors, which was scheduled to be lifted at the end of the week, would be extended. That 6-month ban had been imposed at the height of the Chinese stock market crash in August.

As one might imagine, heavy stock market losses caused the Yuan to weaken and the spread between the onshore and offshore Yuan to widen. At one point, the spread hit its widest level in more than four years after the central bank was suspected to have intervened in the onshore market to support the currency. It's also important to remember that prior to the big August devaluation, the two rates traded at virtually the same level. The difference between the onshore (CNY) and offshore (CNH) market is due to China's wish to try to internationalize its currency. As China began to open its economy, it wanted its currency to be used in the international market to settle trade and financial transactions, without however fully opening up its capital account. The drawback with this dual system is that offshore Yuan is free to trade in the open market while the onshore Yuan fluctuates within a tight band under the control of the monetary authorities. Thus, as the offshore Yuan sold off the central bank of China was forced into intervening in the onshore market to stop the currency from falling too quickly. The bottom line is that the gap implies that external market participants (international investors) are pricing in further weakening of the onshore Yuan.

When the western media sees the Yuan falling they are quick to jump on the devaluation theme with their headlines charging that China is devaluing the Yuan in order to boost its sagging exports.  Buried deep in their articles is the fact that China is spending its reserves to slow down the fall in its currency in order to combat capital flight. Data on Thursday showed China's foreign exchange reserves fell by the most on record last month, down $108 billion in December alone and by $513 billion overall last year. This is a serious rundown in reserves and it cannot go on forever. The depletion in reserves causes monetary tightening, which in turn compounds their economic downturn. In theory, China could cut the reserve requirement ratio for banks (RRR) from its current 18%. This would ease monetary policy but it would also weaken the currency, which in turn would accelerate capital flight. China is trapped in a vicious circle - no country can have an open capital account, a managed exchange rate, and sovereign monetary policy - something must give.

As if market sentiment wasn’t fragile enough, the US Geological Survey detected an unusual 5.1magnitude tremor near a known North Korea nuclear test center. The North Korean regime announced it had successfully carried out its first underground test of a hydrogen bomb - a weapon much more powerful than an atomic bomb. Even though many experts discounted these claims, the test was enough to fan more panic and risk aversion.
By Thursday, China allowed the biggest fall in the yuan in five months sending global stock markets
tumbling as investors feared it would trigger competitive devaluations. And for a second time during
the week, another 7% crash in Chinese stocks in the first 30 minutes of trading caused circuit breakers to kick in and suspend trading for the rest of the day. It became very clear that the ending of the 6-month sales ban for large investors and the new circuit breaking mechanisms for halting trade in volatile markets were feeding on to itself by creating panic. It took a while, but authorities finally realized what was happening and they responded by abandoning the new circuit breaking mechanism and by replacing the sales ban with a less severe rule – large investors would be restricted from selling more than 1% of a listed company's share capital every three months. 

These measures finally helped to calm the markets; however they were poorly communicated and
poorly executed. In our opinion, Chinese financial markets lack a face – someone market participants can turn to for answers. In a well-developed market like in Canada, USA or the Eurozone, market participants can turn to a Stephen Poloz, Janet Yellen or Mario Draghi. They do a very good job of communicating their intentions. China doesn’t have a person that does this; they set out their intentions with press releases, which just doesn't cut it in a time of panic.

China could soothe markets by clearly communicating their monetary objectives. They need someone to say something like this – the central bank of China is in the process of normalizing monetary policy by slowly allowing interest rates to fall. The word "normalizing" would show that it is on the same page as the US Federal Reserve since they are normalizing their monetary policy by slowly allowing interest rates to rise. They could remind the markets that the Yuan has gained by about 30% on a trade weighted basis since 2011 and for the current state of their economy the Yuan is overvalued. China is in the midst of an economic slowdown and they are trying to engineer a transition from an export mercantile based economy to an internal consumer driven based economy that requires monetary easing. This, of course, will weaken its currency against countries that have a neutral or tight monetary policy. If they could have someone consistently bang out that message then fear over opportunistic devaluations would be dispelled and there would be less volatility in all markets.