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Drop in yuan triggers warnings of potential contagion

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At one point on Wednesday, the yuan was down more than 0.5 per cent against the US dollar for a third straight day, an unusually sharp move for the managed currency.

Hong Kong

Global investors might shrug at a bear market in Chinese domestic stocks - largely walled off from the rest of the world. But a tumble in the yuan that has blindsided currency forecasters is now triggering warnings of potential contagion.

Greg McKenna, a three-decade foreign exchange market veteran, said: "I don't talk about the yuan much" in morning notes to clients. But that was not the case on Wednesday. "Folks, you have to watch emerging markets and the Chinese yuan," he wrote.

At one point on Wednesday, the yuan was down more than 0.5 per cent against the US dollar for a third straight day, an unusually sharp move for the managed currency. Such a magnitude had not been seen in a short stretch since China's August 2015 devaluation, when the currency slid 2.8 per cent over two days. It was at 6.5954 as at 4 pm in Shanghai.

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"I expect the yuan to head back toward 6.70 or 6.80," said Mr McKenna, a former currency strategist with Australian banks who is now at AxiTrader in Sydney. "I wonder if that will spook developed markets in a way the fall in Chinese stocks hasn't? I think it might."

The yuan has tumbled about 3 per cent in the past two weeks. While that has left it only at its weakest since December, the drop has coincided with an escalation in trade tensions with the US, spurring concern that China might embrace purposeful devaluation as a policy tool. Surging interest saw yuan options trading rise to the third-most traded globally on Tuesday. A more typical day would see it from seventh to 10th place; it was top on Wednesday in Asia.

"Investors are getting into a bit of a panic now," said Ken Peng, an investment strategist at Citi Private Bank in Hong Kong. "Policymakers might be allowing the market to push the yuan weaker, without doing it themselves, as the trade tensions with the US worsen," and will be wary of burning foreign exchange reserves "to little effect". Even so, "in general, the authorities should still hope to stabilise the market to avoid outflows" of capital, he said. "The drops in the yuan could accelerate as the currency sinks past 6.6 per dollar. The decline will have spillover effects on other yuan assets, such as stocks."

Stability seen in the gap between one-month and 12-month non-deliverable yuan forwards "suggests that the market is not expecting a significant, sustained yuan depreciation to occur", Morgan Stanley currency strategists led by Hans Redeker wrote in a note on Wednesday. By contrast, in past episodes of yuan depreciation, the differential climbed, they said.

"Durable RMB weakness is not our base case, but should any negotiations between China and the US ahead of the imposition of import tariffs on July 6 fail to show positive results, then China may have to rethink its strategy," the strategists wrote.

"Worries over corporate bond defaults are arguably the most dominant factor at this point," said Tai Hui, JPMorgan Asset Management Inc's chief market strategist for the Asia-Pacific in Hong Kong. "The prospects of higher dollar interest rates and subsequent dollar strength are raising concerns that companies who have been heavy dollar-debt issuers could face challenges to service their debt, repay or refinance."

There are reasons for Chinese authorities to prevent sustained weakening in the yuan - including promoting the currency as a rival to the US dollar and its use in commerce with trading partners, said John Hardy, head of foreign exchange strategy at Saxo Bank A/S.

"So I would be surprised, in other words, if the recent pace of weakening is sustained for much longer." Asked why he thought the yuan was weakening, he said that it "could be domestic economic risks, and sending a warning - or simply that the recent yuan appreciation (in basket terms) has proceeded far enough - or all three".

"There is much focus and some expectation in the market of the currency trade tool" being deployed, said Neil Jones, head of hedge fund sales at Mizuho Bank Ltd. "But there is also a strong regard to sovereign divergence in play here. The Fed is raising and the PBOC (People's Bank of China) cutting. I would suggest very strongly that rate differentials are playing a big part."

With the Chinese stock market also diverging in its performance relative to the US, "to me, a weaker yuan seems logical regardless of a trade tool or no trade tool", Mr Jones said. BLOOMBERG