Emerging market currencies have rallied since the start of 2016, driven by largely external factors with a combination of country-specific changes, which included the Brazilian impeachment, shifts in risk sentiment led by US Federal Reserve’s dovish tilt, improved data in China and stronger commodity prices.
“The recent rally faces risks, especially because signs of country-specific fundamental improvement are scarce across most emerging markets,” Wolf said.
Wolf pointed out that EM currencies have been moving closely in line with RMB volatility and with an index measuring broader growth expectations, the Hang Seng China Enterprise Index.
Currency vs reforms
Since February, Chinese leaders have made an effort to stabilise and restore confidence in the currency through strong fiscal stimulus and vocal support for the RMB, Wolf said.
“These moves boosted sentiment in the short-term and eliminated fears of a sharp devaluation. In our view, these efforts are short-lived and eventually the RMB will come under renewed pressure.”
"Policymakers will once again have to choose whether they will continue with capital account liberalisation and accept greater volatility, or stall reform efforts to ensure stability"
Chinese policymakers’ frequent statements about “exchange rate stability” and "an exchange rate set by market forces" are inherently inconsistent, he added.
“Although they reference stability against a basket, the US dollar is still clearly in the driver's seat. The RMB has strengthened against the dollar, taking advantage of broad dollar weakness, but depreciated in trade-weighted terms.”
Capital controls have also played a role, he said. Since December 2015, Chinese authorities have implemented trade invoicing audits, administrative interference in individual convertibility, and suspension of backdoor transfer channels.
“While capital controls can’t effectively stop outflows for such a large economy, they can be effective at the margins,” he said.
Wolf believes that policymakers will once again have to choose whether they will continue with capital account liberalisation and accept greater volatility, or stall reform efforts to ensure stability.
“Investors might be buoyed by a strong response from the central government but, over the longer-term, it is inevitable that investors realise this exchange rate policy is not credibly anchored, especially if the Fed tightens faster than markets are currently pricing. Once fiscal stimulus starts to fade and activity data softens, downward pressure on the RMB and EM currencies could re-emerge.”
There are different views over the development of the RMB. While Schroders has recently warned that risk is growing for the currency to significantly devalue, Stratton Street Capital believes that the concerns on capital flights are exaggerated.
Falcon Private Bank believes that there is a low chance of a sharp RMB devaluation, and the easing currency risks in the emerging markets have provided support to Asian equities.