Today, the China indices reopen after a two-day Victory Day break which the country used to parade their latest defence weaponry. A-shares had fallen 2.2% on the three days leading up to the parade while H-shares fell further while Chinese indices were shut, extending their decline for a fourth week with a 6% fall.

In a research report released this morning, Macquarie Equities Research (MER) believes that the current market valuation is pricing in high hard landing risks and a sizeable Renminbi devaluation. However, MER belies that changes of these happening in the next six month is very low…

Here are excerpts from the MER report dated 7 September 2015:
 
Risk-off mode continued: Last week A-shares fell 2.2% on three trading days leading up to the parade. ChiNext dropped more by 11%. Meanwhile, H-shares declined for the 4th consecutive week by 6.0%. According to client feedback, market focus has shifted a bit from hard landing risks to capital outflows/FX reserves adequacy risks. The current market valuation seems to have priced in high hard landing risks and sizable RMB devaluation, as the MSCI China 12-month forward price-earnings (PE) is traded only at 8.4x. In MER’s view, the chances of these happening in the next six months are very low.

RMB strengthened to reduce depreciation expectations: On Aug 27, MER wrote that “We even see some risk that the RMB would strengthen from the current level of 6.40 as a way to reduce capital outflows.” Since then, the onshore Chinese Yuan (CNY) has strengthened to 6.35 while the offshore China Spot (CNH) is still traded at 6.47, posing a historically high gap between these two. The gap has to narrow due to the presence of arbitrage opportunities. Most likely, the CNH will move towards the CNY, as it’s clear that the Peopple’s Bank of China (PBoC) is determined to stabilize the RMB in the near term. To be sure, MER never believed the devaluation on Aug 11 started a large devaluation cycle, as MER made a clear call the same day that “sizable depreciation (>5%) by year-end is not very likely.”

 
Capital outflows/FX reserves adequacy manageable: MER argued before that the hard landing fears are overdone. MER also believes the current concerns on capital outflows and FX reserves adequacy are overdone as well. The market is paying a lot of attention to August’s FX reserves number, which might drop by $100billion-150billion. However, only a fraction of the money actually flowed out of China. The remainder has just changed from FX reserves to FX deposits in China’s commercial banks. More importantly, it’s problematic to extrapolate the current pace of FX reserves depletion into the next few months, as the selloff pressure would ease if the PBoC could stabilize depreciation expectations. MER believes the intervention by the PBoC is credible, as the FX reserves owned by the PBoC could enable it to intervene not for months, but for years, not to mention that it has the power to impose all kinds of measures to limit currency speculation.

 
The new normal of China’s monetary policy: The key question for the PBoC now is how to unwind the $1.0-1.5trillion carry trade accumulated during the quantitative years as smoothly as possible without posing big shocks to the domestic liquidity system. Probably the best policy mix is to use periodic currency intervention to smooth capital outflows, while maintaining domestic policy independence. It seems to be exactly what the PBoC is doing now. Given $3.7 trillion FX reserves and $500bn annual trade surplus, the PBoC has the capacity to carry out such a strategy for a long time. In the end, the unwinding of the carry trade would cause China’s FX reserves to drop by $1.0tn or more, which is good for China if it goes smoothly.

Source: Macquarie Research - 7 Sep 2015