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Hawkish Fed, weak yuan signal more trouble ahead for emerging markets

Investors will be tempted to pull capital out of the economies; policymakers will be forced to raise rates in response

"For high-yield currencies, the combination of a weakening China and a hawkish Fed is no good." Stephen Jen, CEO of Eurizon SLJ Capital

Hong Kong/Tokyo

IF you thought the first half of the year was rocky for emerging market economies, brace for turbulence ahead with dollar strength and a weaker Chinese currency set to keep investors on edge.

The yuan has slid six per cent against the dollar since June and analysts say if further losses materialise, accompanied by rising Treasury yields and greenback, that will be a volatile mix. Investors will be tempted to pull capital out of emerging economies across the board; policymakers around the region will be forced to raise rates in response. Already, India's central bank governor Urjit Patel has warned of the risk of a brewing currency war.

"For high-yield currencies, the combination of a weakening China and a hawkish Fed is no good," said Stephen Jen, chief executive officer of Eurizon SLJ Capital Ltd in London. In a note dated Aug 1, Deutsche Bank AG said it expects the yuan to trade at 6.95 and 7.40 against the dollar by the end of 2018 and 2019 respectively, compared with a previous forecast of 6.80 and 7.20. China's currency headed for an eighth weekly decline, the longest run since the start of the country's modern foreign-exchange rate regime in 1994.

There's no shortage of diverse views when it comes to the future direction of the yuan. Here's a range of those opinions.

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Freya Beamish, Pantheon Macroeconomics Ltd

For now, markets have had good reason to be calm despite the yuan's slide; so far the yuan has merely retraced its steps back to where it was in early 2017. Last year was politically important so the authorities had a particularly tight grip on capital outflows.

At this stage, trade tensions are helping the yuan to weaken, and we've seen capital outflows beginning modestly to re-build. If, for instance, US President Donald Trump were actually to impose further tariffs, that would cause a further yuan depreciation.

If we get back to where we were at the end of 2016, then I think we'd start to see markets outside of China reacting to yuan weakness.

Chen Long, Gavekal Dragonomics

My best guess is that the People's Bank of China is now experimenting with allowing both the USD/CNY spot rate and the CFETS index to fluctuate in wider ranges over time.

In other words, the PBOC is deliberately reducing its currency market intervention so that its "managed floating exchange rate" becomes less managed and more floating.

In fact, the three-month realised volatility of the yuan has become very similar to that of the yen as well as other Asian currencies.

In my view, it will be changing market forces rather than official intervention that shifts the yuan's trajectory.

Deutsche Bank

We expected the yuan to weaken but the pace of depreciation has turned out to be faster than we expected," economists Zhiwei Zhang and Yi Xiong wrote in a note.

"The PBOC may step in to smooth the path of depreciation but we doubt they will intervene heavily to reverse the trend of depreciation.

Andy Wong, Pictet Asset Management

As its economy re-balances, China is on the verge of having a current account deficit. Our concern is more on whether there will be a one-way expectation of sharp decline for the yuan, and the related damage to private investment and market sentiment, rather than higher two-way volatility.

So far, China FX reserves are not showing a need to panic. For EM risk assets, and global allocation, we believe it is important to be more selective, and be selective on sectors rather than just regions.

For example, we have seen inflows into select EM Debt recently, because of the underlying economy and sector exposures.

Stephen Innes, Oanda Corp

China continues to be the dominant force and the dominant driver of investment sentiment in the region.

If you look at risk in general, I think that's holding back a lot of investments. As China goes, the rest of the emerging markets, especially in Asia, seem to follow suit.

Ian Hui, JP Morgan Asset Management

The trade issues don't look to be cooling down any time soon.

China appears to be willing to let the yuan be driven more by market forces, as it does relieve some pressure on the economy through cheaper exports.

However, Chinese officials will still be wary about letting the yuan weaken too much, causing issues for capital flight and financial stability.

Despite the recent weakness, we expect the People's Bank of China to take a more balanced approach in managing its currency to maintain domestic financial stability.

We don't anticipate the exchange rate weakening past seven against the US dollar this year. BLOOMBERG

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