Eaton Vance
November 08, 2016
Eaton Vance provides advanced investing to forward-thinking investors, applying discipline and long-term perspective to the management of client portfolios.

Markets are too complacent about China’s currency slide

Global Income Team,  Eaton Vance

Boston  - Investors began the year concerned that overvalued Chinese markets posed a threat to financial stability, evidenced by capital outflows that drove a 5% slide of the Chinese yuan (the RMB) against the U.S. dollar in the three months ending January 31.

But even though the RMB slid another 5% against the dollar since March, the weakening currency is no longer viewed with concern (see chart below).

Blog Image November 7

Several factors are behind this turnaround:

  • Capital account tightening: Restrictions imposed by the Chinese to prevent money freely leaving the country helped restore confidence in policymakers.
  • Economic stimulus: The Chinese economy is better off than at the start of the year, helped by stimulus and re-leveraging of various parts of the economy.
  • Basket mechanism: As part of China's plan to make the RMB more responsive to market forces, the People's Bank of China (PBOC) now considers a basket of currencies, in addition to the dollar, in setting exchange rates.

However, in our view, the market has placed too much faith in these temporary factors. As the RMB slides, Chinese households are still likely to make financial decisions based on the U.S. dollar/RMB pair. Early evidence during the third-quarter currency slide supports this. Capital outflow will likely continue. The more hawkish U.S. Federal Reserve will also play a role, triggering expectations of further RMB weakness. Lastly, China's credit binge continues, but this time with less domestic enthusiasm. Corporations and households are growing more concerned about the levered economic system.

Bottom line:  Capital outflows, the Fed and leverage are reasons to be concerned about China, but the market is not listening.

More from Eaton Vance
The most important insight of the day
Get the Harvest Daily Digest newsletter.