Beware what you wish for: calls for China to loosen grip on the yuan may rock emerging and developed markets alike, strategists say

China watchers calling for Beijing to loosen its grip on the besieged yuan need to be mindful of the risk that it unleashes a chain reaction rocking emerging- and developed-market currencies alike, according to some strategists.

Most under threat are the currencies of Asian neighbours such as South Korea and Thailand, where China is the number one trading partner. But a suddenly weaker yuan may have a much wider impact, turbocharging renewed strength in the dollar, the traditional wrecking ball for developing nations’ foreign-exchange markets.

China’s managed currency is seen as an anchor for its regional peers, meaning small moves can have an outsize impact. Last month, a weaker-than–before daily reference rate triggered a slide that pulled down Asian currencies, spilled over to developed names as diverse as the Swedish krona and Canadian dollar, and bolstered havens like the yen and Swiss franc.

“We’ve gone through a period of exceptional, policy-driven stability for the yuan,” said Themistoklis Fiotakis, head of currency strategy at Barclays in London. That is unlikely to last as the “fundamentals point to the fact that the yuan should be weaker, the dollar should be stronger and volatility should be stronger as well.”

Danger signals are appearing that the yuan may be set to resume its slide after four months of relative stability. Aside from the impact of that surprise daily reference rate, pressure looks to be growing with the yuan ominously close to the edge of its fixed trading range against the dollar, a level around which authorities have pushed back with aggressive measures in the past.

The People’s Bank of China has plenty of tools available to it to support the yuan, from direct intervention to creating a dramatic liquidity squeeze in the offshore market, and has shown little intention it wants anything more than currency stability.

On Thursday, it stepped in to bolster the yuan again with a record fixing level relative to estimates after a fresh round of hot US inflation propelled the dollar higher against global peers.

Still, traders will remember the shock yuan devaluation in 2015, which sparked a chain reaction across global markets, sending stocks, emerging market assets and commodities tumbling while giving bonds a boost.

Robust US economic data is damping bets on Federal Reserve interest-rate cuts and bolstering the dollar. That, coupled with China’s gloomy growth outlook is putting policymakers in a bind: either they do more to underpin the currency and risk damaging the economy or tolerate weakness and accept potential capital outflows.

For Barclays’s Fiotakis, China’s economy is also key for the future of the dollar.

“Not just via the yuan, but China’s growth, has an enormous effect on currency markets and on the broad dollar,” he said. “Growth impulses from China are the single most important variable driving the dollar. It dwarfs the Federal Reserve and the European Central Bank over longer windows.”

If the yuan is allowed to weaken, the reverberations are likely to be strongest in Asia. The region’s two worst performing emerging currencies this year – the South Korean won and Thai baht – may be at forefront of further declines, with those of Indonesia and India perhaps less vulnerable as they are already being bolstered by authorities. A number of other Asian peers are hovering near their weakest levels of the year.

A Bloomberg gauge of Southeast Asian currencies shows a strong relationship with the yuan, according to an analysis of 120-day correlations.

Central banks in Asia are likely to take much of their guidance from Beijing in their currency management, according to Wang Ju, head of Greater China foreign-exchange and rates strategy at BNP Paribas in Hong Kong. With officials keeping an iron grip on the yuan and the yen also trading in a very tight range, pressure is building on two big currency drivers in the region.

“If one of the big names lets go of their currency, the range will break and market volatility will surge,” Wang said. Asian central banks may be forced to rethink whether to “move their ranges higher to accommodate the volatility.”

A spike in yuan volatility would also likely disrupt carry trades – where investors borrow in low-yielding currencies to invest in higher-yielding ones, typically in emerging markets. An ideal funding currency is one with low volatility and relative stability – both of which are satisfied by the yuan, but that may not be the case for much longer.

“The concern is can volatility remain as low as it’s been all this while,” said Charu Chanana, head of foreign-exchange strategy at Saxo Markets in Singapore. “We all know the carry trades reverse very quickly, so I would be on guard for that. The markets are really testing the grip of the central bank of China whether they continue to hold it off.”

A resurgent US dollar is already exasperating central bankers and governments around the world, forcing them into action to relieve the pressure on their own currencies. Bloomberg’s gauge of the greenback has climbed over 2 per cent this year.

For Paul Mackel, global head of FX research at HSBC Holdings, a wider risk is as the yuan weakens, this broad dollar strength becomes even more pronounced, thanks to China’s extensive trade linkages.

“You shift from just a strong dollar to an even stronger dollar because the risk is to a broader base,” Mackel said in Hong Kong. “The risk on the dollar is that it ends up being stronger than people think.”