Emerging Market FX: Is China Out of Policy Bullets?

Is China Out of Policy Bullets?

Ahead of this weekends G20 summit investors are worried that after a period of significant and rapid credit expansion following the global financial crisis and years of propping up growth, China may be running out of policy options. Indeed growth has continued to slow despite material fiscal and monetary easing; recent rapid credit expansion has yielded less-than-impressive results; and more recently, elevated capital outflows and swelling depreciation pressures could potentially further constrain China’s policy options.

China can still use fiscal and credit policies to support growth but markets increasingly believe it is very difficult if not impossible to reverse the economic downtrend or property destocking cycle,  China still has ammunition to support growth. It can still increase infrastructure and social spending, underpinned by a bigger deficit and more credit-funded quasi-fiscal spending, to prevent investment and growth from dropping off a cliff. That said, the scope and effectiveness of such measures appear to be diminishing.
High domestic saving can help support further increase in debt, for now Debt and corporate restructuring can help contain China’s leverage issue. However, deflationary pressures and an ongoing need for credit expansion to support growth mean that China’s leverage will continue to rise in the next few years. Though this may increase the risk of even greater debt-related problems down the road, markets think a high domestic saving rate and further bond market development should support debt increase for a while longer without a market-forced credit crunch or sharp deleveraging.
China can still manage Yuan, capital flows and domestic liquidity despite depreciation pressures, China will likely pursue a relatively stable Yuan exchange rate against the basket, with opportunistic and modest depreciation against the USD. To manage this process, China will likely need to tighten existing capital controls and use some of the FX reserves ($500 bn this year), along with policies aimed at stabilizing domestic growth. The PBoC can manage any negative liquidity impact from outflows by cutting still high reserve requirement ratios and using other liquidity facilities.
What to expect from the upcoming National People’s Congress? Markets expect the government to announce a bigger budget deficit, more social and infrastructure spending, an easing bias for credit policies, announcement of new investment projects associated with the 13th five year plan, and more specifics on supply side reforms at next month’s NPC. However, markets generally expect these measures to only help mitigate, not reverse, the slowdown.

Technical & Trading Takeaways

Price broke lower from the holiday consolidation pattern.  I believe there will be an excellent risk reward with trend entry as price retests former spike highs and ascending channel support at the the 6.4900 level where I would be watching for intraday reversal patterns to venture long targeting the topside of the channel. My interest in this trading level has increased with the current price pattern setting up a symmetrical AB=CD decline into the support zone as highlighted in the chart below.


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