Macro Monday China:RMB returns to the center of stage

Shenzhen Connect to be launched on Dec 5: Last week H-share gained4.7%, rising for six consecutive sessions while A-share also rebounded 2.2%.

The “Trumpflation” trade post the US election continued to dominate with achase toward Cyclicals/Financials. Insurance was the best performer in MSCIChina last week thanks to yield curve steepening. Meanwhile, China finallyannounced the SZ-HK Connect will be launched on Dec 5. Our Chinastrategist expects the scheme would give foreign investors 2.5x access to Asharesand also rerate China small caps listed in HK.

Reflation likely to continue in 1Q17: Data released over the weekendshowed industrial profits rose10% yoy in Oct (Fig 49), in line with our call of anew earnings cycle (Thoughts on earnings cycle: A new start? April 2016).

Given the broad strength in commodity prices (Fig 25-30), China’s PPIinflation is set to be higher in the coming months. We expect the currentreflation trend and earnings cycle both to turn around in 2Q17, given theongoing property and inventory cycles. Regarding CPI inflation, we expect itto edge up 2.5% in 2017 (vs. ~2.0% in 2016). While it is unlikely to triggerdecisive policy tightening, the combination of stable growth and mild reflationis supportive to equities but negative to bonds.

Recent depreciation on the strength of US$: Last week the USD/CNYbroke above 6.9 for the first time since 2008. At one level, the recentweakness could be attributed to US$. Since the US election on Nov 8, theRMB has fallen 2% against US$, while euro, yen and the EM currencies haveweakened 4%, 8% and 4%, respectively. As such, the RMB has actuallygained 1% against the CFETS currency basket since then (Fig 46). However,from a longer-term perspective, it’s hard to blame US$ for the current RMBdepreciation expectation. After all, the RMB has depreciated 6.5% against theUS$ from year-beginning while the dollar has only risen by 2.8%. If the RMBonly drops 2.8%, the current USD/CNY should be 6.68 and the depreciationexpectation would be much more muted. Moreover, the volatility is so smallthat the depreciation looks almost like a one-way play. In any case, since theCNY has already dropped 6.5% against the US$ year-to-date, a furtherdepreciation in the remainder of this year could surely lead to higher FXdemand at the beginning of 2017, when the new US$50k quota is available.

Options left for the PBoC: The PBoC now has three options. The first is tostop intervention and let the RMB fall, until the market finds a new equilibrium.

However, the experiences of last Aug suggests that a disruptive CNYdepreciation could trigger a huge market panic, which might eventually forcethe PBoC to back down (it persisted three days last Aug). The second is tomaintain the status quo, letting the RMB peg to a currency basket but weakenagainst the US$. The issue is that a fall against the US$ could furtherstrengthen the depreciation expectation and thereby the capital outflowspressure. The third option is to peg the CNY to the US$. The issue here isthat given the current depreciation expectation, the PBoC needs to spendmore FX reserves in intervention. None of them are pleasant but most likelythe PBoC will choose something between 2 and 3 and wait for the dollar bullrun to ease. Beyond that, for next year, we do hope that the PBoC could takethe lessons from this year by avoiding a one-way depreciation, a sure way tofoster depreciation expectation and thereby capital outflows pressure.