Evergrande Update 3: Default Is Here, Focus Turns To CNY
Evergrande has finally fallen into formal default, and is poised to undergo a major restructuring of its balance sheet. This hasn’t come as a surprise to anyone following the saga, as demonstrated by the Chinese fixed income market not plunging on the news, instead remaining close (and in some cases rallying slightly) to where they were trading in our previous update. What did plunge however, was the CNY, which isn’t a good sign for the rest of the world.
The CNY has rallied about 400 pips, from 6.34 – 6.38 (high to low), and mainstream media outlets have been quick to attribute this rally to the Chinese government’s decision to increase the reserve requirement ratio (RRR) for foreign exchange (FX) deposits.
While this would no doubt have played some role in the CNY’s move higher, it is important to remember that the USDCNY rate is managed by the People’s Bank of China (PBoC). More specifically, the rate is set daily by the PBoC, and only allowed to deviate 2% higher or lower. This is done to allow Chinese banks some leeway in obtaining the USDs they require from global Dollar funding markets, i.e. they can pay more for USDs if they need to.
Consequently, the PBoC’s market fixings are neither entirely policy driven nor arbitrary – they are based on the economy’s demand for USDs, relative to the FX market’s willingness to supply them.
From this perspective, CNYs’ sharp rally over the last two days could be indicative of a turning point in its recent strengthening versus the Dollar. Not just due to policymakers’ actions, but also to a growing demand for USD liquidity in the economy caused by Evergrande’s growing contagion (detailed here).
More importantly, the CNY has been, in recent months, the only major currency to strengthen against the USD. This means that USDCNY is rising in an environment where Dollar financing is already growing tighter. Should the fallout from Evergrande’s and the wider property sector’s default spread to the Chinese banking system and other parts of the Chinese economy, already fragile Dollar funding markets may freeze up entirely.
Watch what happens with the CNY very closely in the coming weeks.
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