Chinese policy makers made it clear this week that they don’t want any surprises when it comes to the yuan.

Three-month implied volatility on the currency is the lowest among emerging markets, as capital controls quell demand for foreign exchange. While Premier Li Keqiang hinted at an increased tolerance for bigger yuan moves at the start of the National People’s Congress, officials are sticking to their mantra. Deputy governor Yi Gang said on three separate occasions the yuan is “stable,” and his colleague Pan Gongsheng emphasized the currency market is “solid.”

Analysts, however, see risks to that outlook, with the potential for volatility on a number of fronts:

1. Hawkish Fed

The U.S. central bank’s monetary policy poses the single biggest risk to the yuan this year, says Gao Qi, a currency strategist at Scotiabank in Singapore. Gao expects three interest-rate hikes from the Federal Reserve in 2017, which would narrow China’s rate advantage over the U.S., making yuan-denominated assets less attractive.

2. The Trump Card

U.S. President Donald Trump has vowed to bring China to account on trade, saying during the election campaign that he’d boost tariffs on Chinese imports and label the country a currency manipulator. A trade war would be “very damaging” to Asia’s largest economy, hitting the current-account surplus and the yuan as well as slowing the pace of structural reform, BNP Paribas SA economists Chen Xingdong and Jacqueline Rong wrote in a note Tuesday.

3. The Economy Stumbles

China’s economy has had a good start to the year, with factory prices surging the most since 2008 in February, and manufacturing accelerating. Data that undermines the idea of a recovery, though, could weigh on the yuan. Furthermore, Sue Trinh, head of Asia foreign-exchange strategy at RBC Capital Markets in Hong Kong, says that in order to meet its 2017 growth target, China will have to depreciate the yuan and rely on higher leverage.

4. Capital Curbs Dropped

While they’ve eased pressure on China’s foreign reserves by sapping demand for external currency, capital controls could be pared back in the second half as the country seeks to maintain and build on the yuan’s new-found global status, says Ken Cheung, a Hong Kong-based currency strategist at Mizuho Bank Ltd. This risks reigniting the outflows that contributed to the yuan’s worst annual slump in more than two decades last year.

5. Regional Tension

China is fuming over U.S. plans to deploy a missile defense system in South Korea, curbing travel to its eastern neighbor and making life hard for Korean companies that operate within its borders. While the spat is yet to have any impact on yuan trading, if it escalates and other countries in the region are involved, all currencies in emerging Asia will see losses, including China’s, says Scotiabank’s Gao.

When it comes to forecasts, analysts are predicting the smallest yuan move since 2012. The median of 45 estimates compiled by Bloomberg is for the currency to slip 2.2 percent this year.

Source:
courtesy of BLOOMBERG

by Bloomberg News

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