(MENAFN- Gulf Times)The biggest devaluation of the yuan in two decades risks aggravating outflows from the currency, pushing up bond yields and sapping cash from money markets unless the People's Bank of China takes action.
The yuan is heading for the biggest two-day drop since 1994, falling 3.5%. The one-year sovereign yield jumped 20 basis points in two days, while the similar swap rate rose five basis points on Tuesday. The PBoC is likely to lower bank reserve requirements and use other alternatives to replace cash leaving the country, according to economists from JPMorgan Chase & Co to HSBC Holdings.
"In order to offset the capital-outflow pressure from currency depreciation, a cut to reserve-ratio requirements isn't far away," Liu Dongliang, Shenzhen-based senior analyst at China Merchants Bank Co, said in an interview.
"Earlier monetary easing policies have had little effect in boosting the economy, and now it's time to use the exchange rate." While the PBoC said that a strong yuan puts pressure on exports, an equally big risk to the world's second-largest economy is an exit of capital should the currency weaken too rapidly. Currency reserves have slumped $315bn in the year to July to $3.65tn. Bloomberg Intelligence estimates that every 1% yuan depreciation against the dollar triggers about $40bn of outflows.
Economists are divided on how much room China has to cut rates. The PBoC lowered its benchmarks four times since November, while the market sees the Federal Reserve raising borrowing costs in September. The additional yield offered by China's one-year sovereign bond over Treasuries almost halved to 189 basis points from 364 a year ago. At 2.54%, the one- year interest-rate swap rate is higher than the 2% benchmark deposit rate. In May, they matched each other.
"The room for further interest rate cuts is not big," said Zhu Haibin, JPMorgan's chief China economist in Hong Kong.
"As the market expects a Fed interest-rate increase later this year, the narrowing differential will be a restriction." Any intervention to support the yuan will lead to a further drop in reserves, leading to volatility in interest rates, Zhu said. The overnight interbank rate for the yuan in Hong Kong fell 82 basis points on Wednesday to 3.26%, after jumping 105 basis points Tuesday.
Asia's largest economy expanded 7% in the first two quarters, the slowest since 2009. Aggregate financing slumped to 718.8bn yuan ($114bn) in July from 1.86tn originally reported for June, central bank data showed.
Both exports and imports declined more than economists projected, customs data showed.
The policy move is a reaction to the export numbers and rising deflation risk, said Liu Li-Gang, chief Greater China economist at Australia & New Zealand Banking Group Ltd in Hong Kong. The PBoC will lower lenders' reserve requirements in August and cut benchmark rates this quarter, he said.
With the yuan depreciation, there will be an even greater emphasis on reserve-ratio cuts rather than benchmark rate reductions going forward, HSBC analysts Andre de Silva and Pin- Ru Tan wrote in a report. It said there hadn't been easing since data showed 94bn yuan of outflows in June.
The central bank should increase domestic liquidity injections to offset the impact on markets of the devaluation, according to a front-page commentary carried on the Xinhua News Agency-backed Economic Information Daily on Wednesday.
Liaoning province raised 400mn yuan at an August 7 auction of 10-year securities, less than its 550mn yuan target. The notes carried a coupon that was 15% higher than the yield on sovereign debt, the biggest premium so far in China's muni market.
"If more local government bond auctions are allowed to fail, market panic could spread fast and lead to a rise even in risk-free central government bond yields," the HSBC report said. "It is therefore likely that the central bank will be tasked to ensure money-market stability."
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