The risk perception for China is rising. Investors are asking which sector will be next following the regulatory crackdown on for-profit education and tutoring institutions. China's equities sell-off, down by nearly 30% since the February peak, is now on par with the 2015 and 2018 pullbacks. The equity market rout is starting to spillover into the currency. USDCNH broke above the key level of 6.50 although still-low implied currency volatility suggests not a lot of bad news is priced in either.
The equity market rout is starting to spillover into the currency but impact so far is modest
Source: Bloomberg, Bank of Singapore
A sustained CNY sell-off is unlikely unless the regulatory risks, ranging from earlier regulatory waves around anti-monopoly issues and fintech to new rules on data security and private education, translate into materially higher macro risks. Margin debt in Chinese equity markets is low while macro support (e.g., fiscal and reserve requirement ratio cut) should increase in 2H21, both of which should limit the impact of falling stock prices on the overall stability of the financial sector and the health of the economy.
Domestic capital outflow risk is also much lower than in 2015, given the availability of more tools at the authorities’ disposal to manage any such outflows. While heightened regulatory risk could weigh on equity sentiment, global investors’ confidence in the China bond market should still be anchored by China’s consistent track record of bond market liberalisation over the past few years.
However, two areas of concern remain. The first, is the uncertain impact on business confidence, which in turn may dampen future capex and economic growth, especially if there is further aggressive sell-off in Chinese shares in the event more regulatory measures are rolled out. The second is the fallout in the Chinese credit market. A disorderly default which risks dragging down the entire Chinese property sector could pose a more material risk to China’s growth outlook, particularly if banks were to remain selective in lending due to rising credit defaults. But this is not our base case.
Weak equity sentiment could weigh on the CNY in the near term. But for now, we believe this regulatory crackdown has little direct macro impact and as such we have not changed our 12-month USDCNY forecast of 6.25. Commodity prices of iron-ore and base metals should be among the first places to watch for signs of spillover from weaker China demand to the CNY and global contagion potential.
We will be keeping a close watch on this week’s July Politburo meeting for clarity about policy intentions. Many view China's recent market volatility as largely under policymakers’ control. If things worsen, policymakers can tone down new regulation initiatives to calm investors’ anxiety on regulatory uncertainty.
A less immediate focus but no less important is geopolitical risk, which could potentially drive CNY price action further down the road. The contentious tone of the US-China meeting between US deputy secretary of state Wendy Sherman and China’s vice foreign minister Xie Feng had limited impact. This round of talks did not seem to have derailed the possibility of a meeting between China’s President Xi Jinping and US President Joe Biden at the G20 this October.Disclaimer applicable to recommendation
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