FX AlertStandard Chartered Global Research | 13 August 2018 2FX strategyDrawing a line in the sandSince CNY depreciation picked up pace in mid-June, markets have been ponderingwhether authorities will draw a line in the sand for the currency. USD-CNY hasclimbed from 6.50 to above 6.80 since mid-June with little signs of resistance fromauthorities, pointing to a high degree of tolerance towards CNY weakness (Figure 2). More recently, authorities have indicated that they wish to slow CNY weakness, asevidenced by the re-introduction of the reserve requirement on FX forwards, officialcomments about the importance of the 7.0 level for USD-CNY and warnings againstherd behaviour. The imposition of the reserve requirement rule comes as theoutstanding long USD forward position in the onshore market has just about reachedthe level last seen in August 2015 (Figure 3). Onshore investor intentions to sell theUSD versus the CNY in forwards have fallen as CNY expectations have reversed.While intentions to sell the USD had recovered, the latest bout of CNY depreciationmay curb this again. The latest rule to impose a reserve requirement may also reduce future imbalancesin the forward market. We see the imposition of this reserve requirement as a pre- emptive move by the People’s Bank of China (PBoC) to forestall market imbalancesand an important signal of policy intention to slow CNY weakness, but this does notchange the fundamentals drivers of the CNY.We do expect the authorities to try to keep USD-CNY below 7.0 in the near term. Webelieve they will be keen to avoid a replay of 2015-16 market conditions and will slowUSD-CNY as it moves above 6.90 and nears 7.0. The authorities mentioned that theysee signs of “cyclical volatility”, but that they retain tools to further control the marketif needed.We agree that the PBoC could re-deploy its counter-cyclical adjustmentfactor in the fixing to slow the pace of any USD-CNY move. The focus of theauthorities on the 7.0 level is likely to anchor market expectations near-term.However, as a result of this anchoring, CNY depreciation expectations couldaccelerate and lead to herd behaviour should USD CNY break above 7.0. Thisreduces the leeway for authorities should market conditions deteriorate; for example,if the USD moves sharply higher or China concerns resurface. Figure 2: Authorities show tolerance for CNY weaknessUSD vs CFETS CNY basket Figure 3: Outstanding market forward positionUSD bnSource: Bloomberg, Standard Chartered ResearchSource: CEIC, Standard Chartered ResearchUSD-CNY(LHS) CFETS CNYbasket (RHS) 91 92 93 94 95 96 97 98 99 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 Jan-18Feb-18Mar-18Apr-18May-18Jun-18Jul-18Aug-18 Sell USD Buy USD 0 50 100 150 200 250 201020112012201320142015201620172018 Authorities are signaling lowertolerance for CNY weakness but arelikely to just slow it downAuthorities have anchoredexpectations such that 7.0 is nowthe differentiation line for CNYbears Downloaded by Ximing Chen at Standard Chartered Bank [13 Aug 2018 02:01 GMT] FX AlertStandard Chartered Global Research | 13 August 2018 3This is not 2015-16Market conditions are markedly different than during the previous CNY depreciationepisode in 2015-16. This time, markets are not showing signs of panic. Flows in theonshore market have remained balanced compared to 2015, when they were heavilyskewed towards buying the USD. Volatility has climbed, but remains well off 2015-16levels. FX reserves for July were flat, suggesting that authorities have not had toutilise reserves to stem CNY depreciation. CNY forward curves have also flattenedas CNY liquidity has been ample. This suggests that markets understand that thePBoC is not fostering current depreciation but that the move is driven by divergingeconomic conditions and weaker sentiment around the US-China trade war. Another important difference is the presence of foreign investor inflows. Theseinflows are crucial in helping to balance China’s cross-border flow picture under asmaller current account (C/A) surplus. Despite recent CNY depreciation, foreigninvestors remain unshaken and continue to add China assets to their portfolio. Thisconfidence is likely a result of China’s continued drive to open its markets to theworld. We believe that this could continue if CNY depreciation does not accelerate,leading to one-sided expectations, and if authorities refrain from taking moredraconian measures to control the market.Trip notesChina clients are bearish on CNY prospects amid trade warWe spent a week in Shanghai and Nanjing meeting financial institution and corporateclients in early August. Client sentiment about FX has shifted over the year. In H1,clients in China still appeared to have a neutral view on FX and expected the CNY tobe stable despite the trade war. But the rapid escalation of the trade war and theonset of China growth slowdown concerns have caused clients to turn more bearishon CNY prospects in H2. Most of our discussions revolved around the ongoing trade war between the US andChina. Clients agreed with our view that it is still early days in the trade war andfurther escalation from both sides can be expected. Most clients expected the tradewar to last beyond the US mid-term elections in November, as the US sees China asa “strategic competitor” and neither side is likely to back down. China clients see thisas a multi-year issue and that China has no choice but to hunker down. Given thestate of the trade balance, China is also forced to take a more reactive role. Theybelieve that the time has passed for China to take a more reconciliatory tone andnegotiations ahead are likely to be much more difficult. There was considerableconcern that the US is seeking to add countries in an alliance against China,especially after news that the US and EU had signed an understanding to movetowards zero tariffs. We found that onshore clients were more bearish about the outlook for the Chinaeconomy and markets than offshore clients. While offshore investors took the viewthat China has shifted to a “marginal easing” bias too soon, onshore investorsbelieved it was necessary for the authorities to take drastic action to safeguard thedomestic economy. Therefore, CNY weakness was inevitable in their view. In fact,we found that onshore investors would be even more bearish on China’s growthprospects if FX weakness were not tolerated. They saw the CNY as being used as atool (not a weapon) to help the economy readjust; some clients felt that anadjustment above 7.0 for USD-CNY was required at this juncture. Markets remain well balanced inmarked contrast to 2015 as foreigninvestors continue to buy Chinaassets Some clients saw the need for USD- CNY to adjust above 7.0China clients expect trade wars topersist past 2018, causing them toremain bearish on the CNYalongside growth slowdownconcernsDownloaded by Ximing Chen at Standard Chartered Bank [13 Aug 2018 02:01 GMT] FX AlertStandard Chartered Global Research | 13 August 2018 4Downward sloping onshore forward curve to be sustainedA by-product of the marginal easing policies onshore has been very flush liquidityconditions weighing on CNY rates, causing the CNY onshore forward curve to invert.The imposition of the 20% forward rule has also affected the balance flows onshoresuch that onshore forward points have continued to fall. The current economictrajectory of the US and China could sustain “flipped” US-China rate differentialsonshore. We expect the US to continue its rate hike trajectory, while China is likely tofocus efforts on cushioning its domestic economy. Alongside this, we expect USD- CNH to gradually flatten and move towards the onshore DF curve. As long as Chinadoes not close cross-border flow channels between markets, flush liquidity conditionsonshore should find their way offshore. While much attention has been given to the fall in onshore CNY rates, it may beworth paying attention to the fact that onshore USD rates have also been falling.Implied rates using onshore SHIBOR and forward points show that flush liquidityconditions persist for the CNY and the USD. In fact, implied USD rates onshorebased on 3M forward points are now close to par with LIBOR rates for the first time inyears. However, onshore foreign currency deposits do not show a rapidaccumulation; total deposits remain flat YTD. Loose USD liquidity may suggestswapped USD sitting idle, but ready to be deployed if needed. The convergence ofUSD rates onshore with those offshore has interesting implications for capitalaccount convertibility, as it would mean less incentive to move funds from offshore toonshore purely based on interest rate differentials. Revisions to FX forecastsWhile we prefer not to change our FX forecasts so soon, we acknowledge thatmarket circumstances have changed and require us to reassess our USD-CNYforecasts. We raise our USD-CNY profile to 6.92 for end-2018 from 6.58 and 6.82 forend-2019 from 6.45. We see the USD as being more neutral from here as most of the Fed story is pricedin. Therefore, the extent of the CNY move will likely be a function of how muchweakness China’s authorities are willing to tolerate. They have been more tolerant ofCNY weakness than we expected, as evidenced by the fall in the basket to the 92-93level on 9 August. We see more headwinds on the horizon, especially in the run-upto the US mid-term elections, in which “China bashing” may be used as a politicaltool. It feels increasingly unlikely to us that a mutual agreement to set asidedifferences on trade will be reached. Figure 4: Onshore CNO DF curve inversion could besustained Figure 5:Both onshore CNY and USD liquidity is flush%Source: Bloomberg, Standard Chartered ResearchSource: Bloomberg, Standard Chartered ResearchCNY NDF CNH DF CNO 6.79 6.80 6.81 6.82 6.83 6.84 6.85 6.86 6.87 6.88 0.00.20.40.60.81.0 Implied USD 3M LIBOR 3M SHIBOR -4 -2 0 2 4 6 8 10 12 201020112012201320142015201620172018 Expect onshore DF curve to remaindownward sloping and fosteroffshore curve flattening Implied USD rates onshore havereached par with LIBOR rates forthe first time since 2010We expect moderate CNY weaknessalongside our more neutral USDoutlookDownloaded by Ximing Chen at Standard Chartered Bank [13 Aug 2018 02:01 GMT] 。。。。。。