PBoC Says It Wants Yuan Volatility: The Worst Scenario For Stocks

China wants a moderate depreciation of yuan while encouraging two-way volatility, according to The Wall Street Journal, which conducted interviews with insiders at the People’s Bank of China.

 Lingling Wei wrote:

The goal, these people say, is to allow the yuan to depreciate modestly this year, while encouraging it to move up and down along the way, like a normal currency. That touch of volatility could make betting against the yuan more expensive, and tamp down the flow of money heading out of the country—a problem for China in recent months.

Officials at China’s central bank have long seen one-way movement of the yuan, either up or down, as a big thorn in their sides. For many years, prevailing investor sentiment was that the yuan had nowhere to go but up, as the Chinese economy hummed along.

The central bank bought dollars and other foreign currency to keep the yuan from appreciating too much, resulting in a doubling of China’s foreign-exchange reserves in just over five years, from less than $2 trillion in early 2009 to nearly $4 trillion in mid-2014.

This is the worst thing that can happen to stocks.

First of all, a weaker yuan is no good for Chinese companies listed in Hong Kong. They make money in yuan but have to report in Hong Kong dollars, which is pegged to the US dollar.Morgan Stanley last week cut its yuan forecast to 7 and then Hang Seng China Enterprises Index by 10% for precisely this reason.

Second, a more volatile currency tampers investors’ appetite for risky assets such as stocks.Credit Suisse strategist Vincent Chan also cut his China stock targets. He looked at currency volatility and price-to-earnings multiples across emerging markets and concluded that markets with higher FX volatility tend to be cheaper. “A possible explanation might be investors demand a premium for currency risk, which suppresses stock market valuation.”

Chan now has 3,150 price target for the Shanghai Composite Index.

Year-to-date, the iShares China Large-Cap ETF (FXI) fell 11.4%, the iShares MSCI China ETF (MCHI) dropped 11.3%, the Deutsche X-Trackers Harvest CSI 300 China A-Shares Fund (ASHR) tumbled 14.4%, the Market Vectors China ChiNext ETF (CNXT) retreated 21.5%.