Why the rebounding yuan is boosting regional markets

But China may still bank on weakening yuan to keep the economy stable at home

One no-brainer for stock traders is to track the US dollar: Regional shares will shoot up whenever the greenback wobbles, and go weak in the knees if it strengthens.

To some extent, this superficial correlation held true last week when trading kicked off for the year. Regional shares moved higher as the US dollar weakened - but these buoyant markets may be dancing, in fact, to the tune of the rebounding yuan.

Readers will recall the jitters that rocked bourses worldwide in the first trading week last year when the Shanghai stock market had to be suspended from trading twice, owing to turmoil blamed on the weakening Chinese currency and clumsily designed circuit breakers.

In contrast, regional bourses couldn't have asked for a more exuberant trading start this year. Widely watched market barometers such as the Straits Times Index rose for the first four sessions of the year, marking their best first trading week for years.

The gains registered in regional stock markets were made against the backdrop of an appreciating yuan, which caught out China bears and pushed the greenback lower around the world.

In just two days last week, the yuan had rallied by as much as 2.6 per cent against the greenback, surging back to levels last seen in November before the US presidential election.

Regional shares moved higher last week as the US dollar weakened - but these buoyant markets may be dancing, in fact, to the tune of the rebounding yuan. PHOTO: REUTERS

This follows a series of measures from Beijing to fend off attacks on its currency that appear to be taking effect finally after burning through nearly US$1 trillion of foreign reserves defending the yuan in the past two years.

Last year, the yuan fell 6.6 per cent against the US dollar, plummeting to its lowest levels in eight years.

From Jan 1, Beijing has imposed tighter oversight of foreign currency purchases as well as tougher penalties for illegal money outflows. While it has kept the cap on annual purchases of foreign currencies at US$50,000 (S$71,700), it requires Chinese investors who want to buy foreign currencies at banks to fill out an application to explain the purpose of the transaction.

What is more, the Hong Kong inter-bank borrowing rate for offshore yuan overnight loans more than doubled to 38.335 per cent last Thursday as short-sellers scrambled to cover their positions, following the sudden rise in the Chinese currency.

The big questions now being asked are whether the rebound in the yuan is temporary and whether it will resume its slide once the squeeze on the supply of offshore yuan eases.

The overnight costs of borrowing yuan offshore then surged to 61.33 per cent the following day. This made the costs for shorting the currency prohibitively high.

That the strengthening yuan should have a big beneficial effect on regional stock markets should not be underestimated.

As this column observed last January, besides directly shorting the yuan, currency speculators had also turned to shorting regional currencies such as the South Korean won and Malaysian ringgit, using them as proxies for the yuan.

That, in turn, caused those currencies' respective stock markets to wobble as the currencies came under attack.

As such, the squeeze that short-sellers must be experiencing as a result of the strengthening yuan will also bring much-needed relief to other regional currencies that may be under siege - and giving their hard-pressed stock markets a much-needed boost.

It is also no coincidence that some of the biggest recent stock market gainers are lenders such as DBS Bank and HSBC Holdings, which have big exposure to the mainland economy.

This is due to easing concerns over the servicing of foreign debts by Chinese firms as the yuan appreciates.

This, in turn, propels the regional stock indexes higher, since they are dominated by bank stocks.

The yuan's sudden resurgence has confounded expectations that it might weaken further this year. Indeed, OCBC currency analysts predict that the yuan will weaken to 7.1 to 7.2 to the US dollar, from about 6.7882 now.

The rebound has prompted some market watchers to speculate that it might be reflecting a desire by Beijing to draw the sting from US President-elect Donald Trump's criticism that China is weakening its currency to support its exporters.

Sure, the disappointing recovery in the developed world after the 2008 global financial crisis threw a spanner into the works of export-oriented economies' growth trajectories - including China, whose manufacturers are no longer able to keep increasing their sales like before. As such, the argument goes that Bejing must guide its currency lower - if only to limit the detrimental impact felt by its citizens as it tries to shift its economic model from one based on investment and external demand, to one underpinned by domestic growth.

But on the flip side, there is the risk that the weakening yuan may encourage rich Chinese to shift their wealth out of the country into stronger currencies - hence the need to impose tighter oversight on foreign currency purchases.

China also needs a lot of capital in order to continue to fund its growth, which is heavily reliant on borrowings.

This is not a problem to be sneezed at. As former US treasury secretary Lawrence Summers once noted, the best indicator of a country's economic prospects is the decision made by its citizens on whether to keep their money at home or send it overseas.

And there are enough wealthy Chinese around to burn a very big hole in China's foreign reserves if all of them want to swop yuan for US dollars at the same time, even if they limit their foreign currency purchases to the annual cap of US$50,000.

The big questions now being asked are whether the rebound in the yuan is temporary and whether it will resume its slide once the squeeze on the supply of offshore yuan eases.

That would, of course, depend on a host of factors. Among them would be the actions the incoming Trump administration may take against China in its quest to punish countries found to "discriminate" against the US.

The yuan may also feel the heat from further outflow of foreign capital as China foots the bills of higher oil prices this year.

So far, regional bourses have experienced a balmy start to the year's trading as the yuan stabilises. Will market conditions continue to stay like this? That may well depend on how the Chinese currency behaves.

A version of this article appeared in the print edition of The Straits Times on January 09, 2017, with the headline 'Why the rebounding yuan is boosting regional markets'. Print Edition | Subscribe