Interactive Investor

The number one currency play for China investors

18th January 2017 10:49

Luke Spaji from ii contributor

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

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".

Capital outflows to continue

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 (342,000 yuan, £41,000) 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 US dollar by a mid- to high-single-digit percentage.

We forecast a slide in Chinese GDP growth to 6-6.5% in 2017 from the current 6.7%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.

We still favour long positions in US dollar versus the yuan and other emerging Asia currenciesBut 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 US interest rates in 2017 (we anticipate two to three increases) and the Chinese yuan continues to decline, we still favour long positions in the US dollar versus the yuan and other emerging Asia currencies.

Luke Spaji leads emerging markets portfolio management in Asia and manages Asian credit portfolios at PIMCO.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.