Special
Second vs. Third: FX wars ahead?
Financial Markets Research
19 November 2014
Marketing Communication
www.rabotransact.com
 Has the BOJ fired the first shots in another round of currency wars?
Michel Every
Head of Financial Markets
 JPY’s depreciation has been remarkable – most so vs. CNY
Research, Asia Pacific
+852 2103 2612
Michael.Every@Rabobank.com
 With a slowing economy, how long until China responds?
Major swings in a major FX cross
The ‘Halloween special’ end-October BOJ meeting has seen USD/JPY subsequently test 117, the lowest
level since 2007; indeed, having stood at 76 at the start of 2012, the recent pace of decline is remarkable
even for a currency as volatile as the Yen. We explored the reasons for this radical step from the BOJ in a
recent special: in short, with domestic demand structurally weak, and global demand flagging due to a
similar legacy of very high debt levels, Japan is using QE and JPY devaluation as a deliberate strategy
(though whether making its population significantly poorer in foreign currency terms actually helps is a
pertinent question: while the Nikkei was +4.2% YTD at the time of writing, it was still -5.3% in USD
terms).
Since the start of 2014, JPY has declined by over 10%. By contrast, CNY is down just 1.2% - and has been
strengthening for much of this year after a brief sell-off in Q1. In fact, since the end of Q1 JPY has
weakened by 12.5% while CNY has strengthened by 1.5%; since the end of Q2 JPY has weakened by
14.7%, and CNY strengthened by 1.2%; and just since the start of Q3 JPY has still weakened by 5.9% and
CNY has gained by 0.2%.
Yet even this does not fully capture the scale of the shift in CNY/JPY recently. USD/.JPY at 117 is still well
within the range of recent experience: it was over 123 in 2007, and nearly 135 in 2002. By contrast,
CNY/JPY is now back at a level last recorded in late 1993. At that time China’s GDP was less than
USD500bn, while Japan’s was 9 times larger at USD4.5 trillion (and ironically higher than it is today).
Rapid economic development in China since then should naturally have been reflected in exchange-rate
appreciation – but a 35% CNY/JPY surge since January 2013 is hardly gradual - and adjusted for inflation
CNY/JPY is even higher despite the recent sales tax-related spike in Japanese inflation.
Chart 2 –CNY/JPY at a two-decade high
JPY
KRW
NZD
SGD
MYR
AUD
VND
CNY
PHP
THB
IDR
INR
CNY/JPY
200
22
180
20
160
18
140
120
16
100
14
80
12
-12
-10
-8
-6
-4
-2
0
10
Jan-93
Change vs USD since Jan 2014
Source: Bloomberg
Page 1 of 1
220
24
60
40
Jan-98
Jan-03
CNY/JPY - LHS
Sources: Bloomberg, Rabobank
Please note the disclaimer on the last page of this document
Jan-08
Jan-13
Real CNY/JPY - RHS
Real CNY/JPY, 1990 = 100
Chart 1 –Spot the odd one out!
Second vs. Third: FX wars ahead?
19 November 2014
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Up, up, up...and down, down, down
This matters. While CNY/JPY was not historically a cross worth considering, it is of increasing importance
as China moves up the value-added ladder in production. The ratio of exports of high skill and/or
technology exports between China and Japan has shifted markedly in recent years, underlining that
China is no longer producing only basic goods, and Japan advanced ones. Indeed, while China obviously
dominates labour-intensive and low-skill industries (fields that Japan abandoned decades ago as it
developed), China now exports almost as many high-skill/technology intensive goods to Japan as Japan
does back to China – by contrast just five years ago Japan exported 25% more such goods to China than
it bought from it (see Chart 3). Moreover, within a global rather than just a bilateral context China is also
increasingly going head to head with Japan. In line with the growth of its overall economy China now
exports four times as many high-skill/technology goods to the rest of the world as Japan does, whereas
nearly twenty years ago it was Japan who was exporting three times more than China. True, some of this
is ironically from foreign (even Japanese)-owned plants, and the very highest technology and quality
sectors today are still dominated by Japan, but the trend is clear.
0.8
0.6
0.4
0.2
0.0
1995
1998
2001
2004
2007
2010
2013
Low-skill and technology-intensive - LHS
5
30
4
25
20
3
15
2
10
1
5
0
1995
0
1998
2001
2004
2007
2010
2013
Low-skill and technology-intensive - LHS
Medium-skill and technology-intensive - LHS
Medium-skill and technology-intensive - LHS
High-skill and technology-intensive - LHS
High-skill and technology-intensive - LHS
Labour-intensive and resource-intensive - RHS
Labour-intensive and resource-intensive - RHS
Sources: UNCTAD, Rabobank
Ratio of CH to JP exports to world
8
7
6
5
4
3
2
1
0
1.0
Chart 4 – ...to export more than Japan
Ratio of CH to JP exports to world
1.2
Ratio of CH > JP to JP > CH exports
Ratio of CH > JP to JP > Ch exports
Chart 3 –Moving up the value-added ladder...
Sources: UNCTAD, Rabobank
Yet China’s domestic economy is slowing, placing it under pressure to retain export competitiveness.
Industrial production growth is now down to just 7.7% YoY, approaching the lowest since the Global
Financial Crisis; and deflation threatens: headline CPI inflation is now only 1.6% YoY, and PPI has fallen
YoY for nearly three years. At the same time, China’s aggregate financing data for October saw new
liquidity rise just CNY663bn (USD108bn), around half of the CNY1,136bn (USD185bn) recorded in
September, and the lowest monthly increase since July’s shocking-low CNY274bn print; indeed, strip out
that July figure and October’s was still the lowest pace of debt increase since September 2011. Our
special reports this year have repeatedly stressed the critical role of credit dynamics to economic growth
in general, and to China in particular, as it struggles with an overhang of debt: the October financing data
therefore underline the need for China to maintain export growth to support GDP growth ahead.
Chart 5 – Output growth heads for GFC lows...
35
15
30
10
5
Chinese New Year
volatility
20
YoY%
YoY%
25
0
15
-5
10
-10
5
GFC low in output
0
Jan-94
Jan-99
Jan-04
Jan-09
Industrial production
Source: Bloomberg
Page 2 of 2
Chart 6 – ...and nearly 3 years of PPI deflation
-15
Jan-97
Jan-02
PPI industrial products
Jan-14
PPI consumer goods
Source: CEIC
Please note the disclaimer on the last page of this document
Jan-07
Jan-12
PPI producer gooods
Second vs. Third: FX wars ahead?
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Chart 7 – Exports adding less to M2 growth
Contribution ppt to YoY 3MMA growth
YoY ppt contribution to M2 growth
35
Chart 8 – Hong Kong, ‘others’ drive exports?
30
25
20
15
10
5
0
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13
Net Foreign Asset
Sources: CEIC, Rabobank
Net Domestic Assets
20
15
10
5
0
-5
-10
Jan-12
ASEAN
Japan
South Asia
M2
Jan-13
EU
US
Total
Jan-14
Hong Kong
Other
Sources: CEIC, Rabobank
Indeed, as Chart 7 above shows, China’s M2 growth is steadily slowing in YoY terms in tandem with
credit growth. Crucially, net foreign assets are making a much smaller contribution to M2 growth than
prior to the Global Financial Crisis: that is largely because the cash inflow from net exports is
substantially less than it previously was. If that doesn’t change then China’s net domestic assets (i.e.,
credit) will need to grow even faster to compensate – but we know that the opposite is actually
happening.
One might argue that this is not a concern as Chinese exports are still competitive, rising 11.6% YoY in
October (see Chart 8). However, strip out suspicious sales to Hong Kong (which accounted for more than
to the EU!); some of the apparently buoyant sales to the US; and presume that Japanese sales will drop
sharply ahead (they were -8.0% YoY in October), and the outlook is far less positive. At the very least
there does not appear to be enough momentum to mitigate for a sustained slowdown in domestic
demand. In short, Japan’s sharp currency devaluation is therefore an economic slap in the face from the
third largest economy to the second. Moreover, this is not factoring in that the ECB are also happy to see
a weak EUR: EUR/CNY has already moved from 8.70 to 7.63 since May, and given the EU accounts for
15% of Chinese exports (vs. 6% for Japan), further gains there will be most unwelcome. Indeed, if the ECB
gets dragged into this FX war too, where it all ends is hard to predict – though “not well” is the historical
experience.
Say “Mmmmmm”?
So what can China do? The problem is that Beijing is pressing ahead with reforms of its exchange-rate
regime; CNY can now float up to 2.0% on either side of central fixing, and is rapidly internationalizing.
Yet structural economic reforms are lagging, which maintains growth at an artificially high level (GDP
growth is slowing, but is still around 7%): that combination attracts capital inflows. Meanwhile China’s
monetary policy is instead being held firm as a blunt instrument to dampen credit demand (a necessary
evil given high debt levels): and that also means CNY is an attractive carry trade. Indeed, the irony is that
while Japan and the Eurozone may be true market economies, they are nonetheless willing to resort to
QE to push their currencies lower (as was the US before them), while China, where the state is still far
more of a player, is not: that combination spells sustained CNY appreciation - unless China responds in
kind.
Of course, we have already seen a period of CNY depreciation, back in Q1 this year. Recall that after
hitting 6.04, USD/CNY slid as far as 6.26 in April before then steadily reversing trend again. It is widely
recognized that the PBOC, rather than the market, was the driver behind that sell-off. As we discussed at
the time, the Chinese authorities wanted to send a message to investors that the rally in CNY had gone
far enough; the unit was to be seen as a two-way bet rather than a one-way “carry trade”. However, as
soon as the PBOC stepped back, an inexorable trend towards appreciation reasserted itself – despite the
deterioration in domestic fundamentals: even export over-invoicing on the part of Hong Kong firms to
bring cash into China appears to have returned based on the recent trade figures (again, see Chart 8).
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In short, after a period of patience from the PBOC during which CNY has drifted sideways, it seems
increasingly likely that we will see another PBOC-inspired sell-off ahead: it may even be in Q1, as before.
The larger question is, with far worse domestic and international environments to grapple with, will the
CNY reversal this time be larger and/or more sustained? There is clear motive; and the fall in global
commodity prices also offers opportunity. Cheaper import bills give China room for maneuver from an
input cost-perspective; true, it could also respond with export price cuts - but that would exacerbate
deflationary pressures, the last thing a heavily-indebted economy needs (which is why so many others
are resorting to currency devaluation.)
6.50
6.45
6.40
6.35
6.30
6.25
6.20
6.15
6.10
6.05
6.00
Jan-13
6.6
6.5
6.4
6.3
6.2
6.1
6.0
Jan-11
Jan-12
Jan-13
CNY
Chart 10 – ...but becoming an ‘M’ in 2015?
Jan-14
PBOC fixing
4.5%
6.7
3.6%
Chart 9 – CNY: an inverted ‘U’ in 2014...
Jan-14
CNY
Sources: Bloomberg, Rabobank
Jan-15
PBOC fixing
Sources: Bloomberg, Rabobank
Of course, forecasting exactly when CNY will move, and how much it will move by, is very difficult: but
suffice to say it is unlikely to be in a straight line. But overall, we expect an amplified 2014 redux in 2015:
a larger CNY sell-off, and a more sustained sell-off. Recall that in 2014 we saw a 3.6% sell-off at the peak,
so something larger than that, to send a clearer message to the markets, would take us to around the
6.30 level in Q1, and to perhaps 6.40 in Q2, before possibly again fading into H2. However, this is in turn
dependent on the counter-response from the Japan, Europe, and perhaps even the US; yet while the
PBOC didn’t start this FX war, it seems unlikely that is going to be the one who loses it.
USD/CNY
Page 4 of 4
19-Nov
6.12
3m
6.30
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6m
6.40
9m
6.30
12m
6.25
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