Chinese Government Must Choose Between Supporting Yuan Or Stocks

Beijing will increasingly have to choose between propping up the equity market and defending the currency from further downside pressure. The government will not be able to do both.

Both the local stock market and the currency are significantly overvalued, and the veil of government support for both markets has been pierced, giving way to free market forces. We continue to expect lower equity prices and further weakness in the yuan.

While downside pressure on the CNY has abated in recent days, we expect this to prove temporary. As Beijing liberalises the currency over the coming months, allowing it to float more freely, outflows are likely to overwhelm inflows. It is worth noting that China's private sector external balance sheet is far from the bastion of strength that many assume, and is actually in the red, leaving the currency at risk from foreign asset repatriation.

The largest threat, however, comes from domestic residents looking to accumulate dollars amid fears over further currency weakness as the economy slows, which could become self-fulfilling. The current account surplus, while providing support for the currency, is small relative to the past, and is likely to deteriorate going forward as a result of the CNY's real effective exchange rate strength.

Faced with natural downside pressure on the yuan, the People's Bank of China (PBoC) is likely to continue drawing down reserves to prevent aggressive weakness, which will reduce liquidity from the domestic financial system. Indeed, the PBoC will have to sharply slow the growth of domestic money supply in order to firm up the value of the yuan, and this will weigh heavily on domestic asset prices.

Economic Stimulus Entails Compromise Of Equity, Currency Weakness

With the economy facing the combination of bubble valuations, deteriorating earnings, and a reversal of bullish sentiment, we believe that the only factor that can prop up the domestic equity market is continued aggressive monetary easing and/or direct government purchases.

If these actions are pursued, however, the currency will become a predictable casualty as residents are likely to lose confidence in the yuan as a superior store of value to the US dollar, which is likely to benefit from monetary tightening. Overall, the PBoC will almost certainly be forced to accept a balance of lower equity prices and a moderately weaker currency, using its available tools to try to prevent a major move lower in either asset. This will be the best compromise in terms of the real economy, as Beijing's real GDP growth target of around 7.0% will continue to require accommodative monetary policy, which will necessarily entail a rate of money supply growth which will erode the CNY's value.