Chinese Yuan risk to return?

Earlier in 2016, all markets became transfixed by the depreciation in the Chinese yuan and signs of large capital outflows. With economic indicators also weak at the time, many became concerned that this was the beginning of a negative spiral of deleveraging and capital outflows which would ultimately require a big depreciation in the yuan.

Since then, much of that immediate alarm has dissipated. Indicators of activity have tended to be a little stronger than expected, while the level of foreign exchange reserves has been much more stable compared to the massive declines seen in late 2015.

The Chinese Yuan has continued to depreciate over the past 6 months. But this hasn't rattled markets the same way it did earlier in the year. The differential between onshore and offshore has also been more stable.

But while the situation has stabilized in the last 6 months, this does not mean the underlying problems that created the initial panic have not been solved.

The inflection point in Chinese growth in the last few months has been accompanied by a re-acceleration in credit growth, which is seen as problematic given the massive expansion in credit since the 2008/09 global downturn. China has yet to show a propensity to transition the drivers of economic activity without dropping to levels that prompt policymakers to turn back to monetary stimulus.

With money and credit growth indicators now starting the slow, the risks are that real economic activity will start to slow in the next 6-12 months, with property markets already passing the point of maximum growth. Slowing growth is likely to reignite the concerns around capital outflow and the yuan that we saw in late 2015. This could be magnified by hike in the Fed Funds rate, which on the current trajectory looks likely before the end of this year.

It may be the case that the herd mentality will not be as acutely focused on this issue given we have experienced this before with some degree of resolution. But this is a large risk to many markets in the next 6-12 months.