Coronavirus: The PBOC and the possible Yuan Devaluation

It is logical to think that as the total confirmed cases of Coronavirus crosses above 20K and continues to increase, the likely economic impacts of the virus grow. Within a matter of weeks, the virus became officially worse than SARS in number of cases and in total deaths.

Currently, two-thirds of China's entire economy is closed for an extended holiday to keep people from going to work/outside where they may become infected. The extended holiday is supposed to last until the second week of February, but there is little reason to believe that the virus will be less of a problem by then.

As China continues to whirl from the spreading coronavirus, the world is looking for a familiar entity to pounce in and save the day: the People’s Bank of China (PBOC). In fact, last Monday the PBOC announced a massive reverse repo program along with short-term rate cuts.

That said, even though injecting liquidity can give an economy a shock that often brings growth with little inflation, this does not seem the case for China at the moment.

Given that the economy is falling due to an inherently supply-side problem like a virus, injecting liquidity is a recipe for hyperinflation. People are not going to work and are rarely leaving their homes, limiting production. If there are few goods available to buy (due to a lack of supply and sold-out stores), artificially increasing demand in the face of falling supply can cause prices to rise very quickly.

The result of this being a large potential slide in the Yuan exchange rate.

China's Inflation Problem

For over a decade, the goal of central bankers has been to reach its inflation target. However, many emerging market countries have been struggling with high inflation and currency devaluations for years. China was generally resistant to this problem with an inflation rate below 2 percent from 2012 to 2019, but in December 2019 the China CPI YoY price growth rose to nearly 5 percent.

From macroeconomic data, it is clear that the country's high inflation rate is due largely to its roughly 19 percent food inflation rate. Food prices are rising so fast in China due to the death of roughly half of its pig population. This has been made worse by the resistance to importing U.S. pigs to make up for the shortage.

To make matters worse, over the past few days a second virus has broken out in China – the bird flu. The country has already scrapped nearly 18,000 chickens and they are the country's second major source of protein, so this may only make food inflation worse.

China has instituted measures to try to fix retail prices but that may only further worsen the shortage. The fact that the PBOC injected tremendous liquidity into the Chinese economy may cause the shortage to turn into even higher inflation.

PBOC Policy

If short-term interest rates are below inflation, borrowing money is profitable, so inflation rises and exchange rates drop (also due to low demand from foreign investors). Conversely, if interest rates are above inflation, foreign investors can make a profit by lending and exchange rates rise while inflation generally falls.

In China, inflation is 4.5 percent and will likely go higher this month due to shortages and potentially due to concerns regarding liquidity injections. Until October 2019, China’s monthly inflation rate first rose by 3 percent but further increased after that. The PBOC then cut its reverse repo rate from 2.6 percent to 2.5 percent and further cut it last Monday. This means that the county's real interest rate is now -2 percent or lower.

That said, there are other ways the PBOC could continue to try and help the economy. The fact that China’s foreign exchange reserves unexpectedly rose by USD 7.57 billion should help the economy provide more stimulus but in turn devalue the Yuan again.

CNY/USD

When the news of the Coronavirus outbreak first made its way to markets, the Chinese Yuan fell 1.91 percent against the U.S Dollar. That said, after the PBOC said that the impact of the virus outbreak to the economy was only temporary, the Yuan barely changed and in fact rose back up to pre-coronavirus levels. The former also added that it was closely monitoring the situation and preparing policy reserves to offset pressure from the outbreak. Should the PBOC provide more stimulus though a devaluation will probably be seen again.

The Bottom Line

Overall, the event that the Chinese Yuan is headed lower is definitely possible. The currency had had a brief rally on the back of better-than-expected economic news, but the Coronavirus is quickly jeopardizing any bullish economic outlook for China. In fact, S&P already revised GDP growth from 5.7 percent to 5 percent.

This article was issued by Maria Fenech, Credit Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.