Yuan story will play out slowly
Morgan Stanley FX analysts highlight the risks around yuan devaluation in a note today. The market is seeing the shift to 7.04 from 6.87 as an adjustment but it could be a regime change. Moreover, it has knock-on effects that are difficult to see.
"China's FX policy may have wider implications than assumed by many," they write.
One is that it could cut inflows into emerging markets. That dearth of liquidity could undermine central banks' abilities to act on fear of pushing out more capital. In turn, that would stifle global growth.
Another issue is China's weakening current account. It will soon face pressure to attract long-term capital in order to keep the yuan stable. If not (and that looks like a safe bet at this point) then China will have to allow they currency to depreciate further or sell FX reserves.
At this stage, markets will have to assume the stabilising RMB coming at the expense of China's currency reserves. Hence, the most likely scenario suggests China allowing the RMB to drift lower but keeping volatility within tight ranges. Implicitly, investors who hold a more benign view on risk assets may head towards disappointment as the RMB moves lower.
