Goldman sees rising risk of China's yuan repeating January rout

[NEW YORK] There's a growing risk that capital outflows from China may accelerate as the yuan weakens, spilling over into global markets and causing a broad selloff similar to those in January and August, according to Goldman Sachs Group Inc.

"We shift to an outright negative view" on the yuan, strategists led by Robin Brooks wrote in a note Thursday. As the People's Bank of China guides the yuan lower against the dollar, "the risk is that this re-ignites capital flight in the same manner it did in August (during the mini-devaluation) and around the turn of the year," they said.

The yuan is poised for the fifth weekly decline, the longest losing streak since December, amid mounting expectations the Federal Reserve will raise interest rates this quarter. In January, Chinese currency weakness triggered a global equity selloff amid concern the government may engineer the second devaluation since August to bolster growth. By March, the Fed cut its forecast for its long-term borrowing costs, citing uncertainties in China.

The Chinese currency fell 0.04 per cent to 6.5850 a dollar as of 4:44 pm in Shanghai, extending this week's loss to 0.3 per cent. The freely traded offshore rate dropped 0.25 per cent since May 27 to 6.5930. The PBOC weakened the fixing by 0.16 per cent Friday to 6.5793.

China has shifted its management of the yuan, keeping it steady against a basket of currencies while downplaying the significance of the exchange rate versus the dollar. Such a strategy may not succeed in stemming capital outflows because it is the dollar-yuan exchange rate that Chinese households and companies are most sensitive to, the Goldman Sachs strategists said. In turn, the yuan's decline threatens to slow the pace of the Fed's tightening of monetary policy, they said.

"We see a good chance that markets will again speculate over the need for a one-off devaluation, even if the message from policy makers has been that this is not on the cards," the strategists wrote.

Speculative bets against the yuan still appear to be subdued. Neither forwards points nor measures of option volatility have risen much. At least one large Chinese bank was selling dollars to keep the yuan stable on Wednesday as the currency approached a five-year low, according to two traders.

"There's less speculative interest in being short the yuan," Tommy Ong, managing director for treasury and markets at DBS Hong Kong Ltd., said Wednesday. "The official intention is quite obvious: if the yuan weakens to the extent that it threatens stability, they will intervene."

China's 10-year government bond yield rose seven basis points this week to 3.03 per cent, the biggest weekly increase for benchmark notes of that tenor since the five days ended April 8. The nation's money markets typically tighten in June as banks hoard cash ahead of quarter-end regulatory checks. The benchmark Shanghai Composite Index gained 4.2 percent this week, halting a six-week run of losses.

Bonds have fallen because "the market is concerned about mid-year factors, yuan depreciation and rate hikes overseas," Guotai Junan Securities Co analysts led by Xu Hanfei wrote in a note. "After June, the market may return to a bull run driven by weak economic fundamentals."

BLOOMBERG