Fundamental Forecast for the Yuan: Neutral

The yuan offshore rate (CNH) gained slightly against the dollar last week as the Chinese central bank continued to slow the pace on devaluation in the yuan. PBOC set the reference rate for the currency (CNY) near 6.5580 and tightened yuan liquidity at yuan’s largest offshore market, Hong Kong, in order to stabilize the currency. It shows that yuan’s offshore rate is still very much controlled by onshore factors. This week, the following three key themes will have mixed forces on the yuan: the Chinese stock market, the coming holiday season, and the bilateral floating regime.

The first factor is the Chinese stock market. As we discussed in previous weeks, when there is a fire at the equity market, it is less likely for the central bank to react by aggressively devaluing the yuan. This week the equity market is likely to continue to see high volatility, though not necessarily via sharp drops. The main characteristic of Chinese equity market is that over 80% of transactions in the Chinese stock market are made by retail investors. A large number of them do not have enough professional knowledge about stocks to make independent decisions. They usually rely on news or rumors as well rather than on solid information or analysis. So when they see stock prices started to drop or others sell, they began to sell their holdings as well out of fear. When price falls too low for a sale to make financial sense, many stop selling temporarily.

Once the market pulls back above the breakeven point, they will start to sell their holdings again. This can explain a lot of the high volatility we saw this week: when the prices recovered a bit, a group of people felt (not necessarily calculated) they can accept the price and sell their holdings, and then the prices fell once again. And the cycle repeated. Thus, this week investors will want to continue to keep an eye on the equity market, especially on the volatility.