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China Needs to Balance Domestic Growth and International Confidence

The recent Chinese currency devaluation and
the country’s ongoing struggle with its plunging equity markets, were likely
the key trigger for the contagion that rocked financial markets globally last
week.

While the sharp losses recorded in equity,
currency and commodity markets have recovered in the main, due largely to
soothing Fed speak and a sharply higher-than-forecast second quarter US GDP
figure, investors’ focus will remain firmly on the east as China struggles to
find a new way of revamping the country’s ailing economy.

Chinese markets opened the week slightly
weaker but trading was much more subdued, in spite of reports that the
authorities had instructed local brokerages to increase their buying of stocks
just as the government itself said it was no longer going to pump money into
the equity market. In morning trade the benchmark Shanghai Composite Index was
down just over 2.5% but still above the psychological 3,000 level.

The RMB meanwhile was stronger, the offshore
USDCNH pair falling just under 200 points in morning trade while the onshore
USDCNY pair dropping around 100 points.

While China will be aware of the
international knock-on effects of its recent policy moves, and will want to be
seen as a responsible citizen, analysts agree that the country’s focus is still
overwhelmingly domestic as it tries to find a way to rebalance both an ailing
domestic economy and slowing international demand.

John Hardy, head of FX strategy at Saxo
Bank, believes that the recent lowering of the peg to the previous band was the
first step down this road, showing that China is taking back control of its
monetary policy, “which was difficult and more expensive under the old regime
of the semi-peg.”

With China actively pushing its currency
for a place in the SDR, the country however will not want to be seen as being
too aggressive in loosening monetary policy and sparking another round of
currency wars among its trading partners. With a more reasoned and controlled easing
of the currency, and as the yuan eventually gains credibility as a currency for
trade transactions “it will enable a much needed deepening and opening up of
Chinese capital markets,” according to Hardy.

Analysts at Bank of America Merrill Lynch
believe that China should also become more proactive in their approach to
healing its economy and forecast further rate cuts this year although at a
gentle pace, noting, “China needs to get ahead of the curve, via more easing in
interest rates and the RRR, to help domestic growth and to build international
confidence. We expect another 25-50bps interest rate cuts and another 50-100bps
easing in the RRR this calendar year.”

While a loosening of monetary policy may
help stoke domestic demand, China’s current low level of demand for oil and
commodities, combined with a weaker currency, is transferring deflationary
pressures across its borders, a situation that policy makers must take into
account when guiding the yuan lower.

With a 10% fall in the yuan equivalent to a
5% fall in the price of oil, according to estimates from Bank of America
Merrill Lynch, China will need to take a steady approach to inflating its
economy, while at the same time re-building international confidence, otherwise
the events of last week may become a more regular occurrence.

nick@profit-Loss.com  Twitter @Profit_and_Loss 

Colin Lambert

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