China rates cut not to plunge yuan

The Chinese yuan will not drop significantly amid interest rate cuts, with impacts of declining yields offset by increasing trade surplus and dwindling worry over financial stability.

China's move to cut borrowing rates by 0.4 percent, at the backdrop of the ending of the U.S. QE, may make yuan-denominated assets less attractive to international investors who already see an end to the yuan's single-way appreciation.

A depreciation trend caused by the narrowing disparity between domestic and overseas interest rates will then spur more sales of yuan products, pressuring the currency to further go down.

The scenario, however, is only likely to happen after additional rounds of interest rate cuts and the increase in interest rates in the United States.

Ding Shuang, senior China economist at Citibank, said he expects the Chinese yuan to weaken slightly against the U.S. dollar by the end of next year after the forecast of two more rounds of rates cut in China and the rates increases in the United States.

"The yuan will depreciate after additional rates cuts. Without more cuts of interest rates next year, the yuan will not go down against the dollar," Ding said.

He believes the yuan, pressured by possible capital outflows, may only weaken against the strong U.S. dollar but appreciate against other currencies.

While currency depreciation is a common option to boost growth, China is unlikely to employ the policy even after its GDP growth slid to a five-year low in the third quarter.

"The Chinese government will never use the depreciation of yuan to prop up economic growth," said Chang Jian, Barclays Chief China Economist.

China's resolve to internationalize its currency will make the Chinese yuan stay stable at the current level, Chang said.

Liu Linan, senior strategist at Deutsche Bank, said there is no need to worry about capital outflows, as increasing trade surplus, partially boosted by the U.S. recovery, will support Chinese yuan. "The current account will play a bigger role," she added.

Liu believes the Chinese yuan will maintain a comparable exchange rate to the current one next year, with some two-way fluctuations, since slower GDP growth will also prevent the yuan from appreciating.

In the short-term this round of interest rates cut may help, not hinder, to rally yuan appreciation as the move sends a clear signal that the Chinese government will act strongly to maintain economic growth at a relatively fast pace.

While noting the yuan may be less attractive from a yield perspective, Nomura believes the interest rates cut will be a near-term positive for the yuan, as the cut reduces growth slowdown concerns as well as the associated risk of capital flight.

"Reduced expectations of a potential sharp China economic downturn are likely to lead to a pick-up in capital inflows," Nomura said in a brief report.

The cut will help reduce the debt burden and lower financial risks, Barclays' Chang said. It will also support business sentiment and sustain private demand.

The value of the yuan strengthened by 30 basis points against the U.S. dollar in its central parity rate on Tuesday opening after a 200 basis points drop on Monday.

The interest rates cut may also dampen concerns over China's property market and local government debt, which seen by many as the biggest risks to the world's second largest economy.

The interest rates cut will allow local governments to breathe more freely when facing their trillions of debt, a big proportion of which will be due soon.

Although only a limited number of financially robust property developers can obtain loans directly from banks, the benchmark rates cut can bring down the overall social borrowing costs, thus alleviating debt burdens on the property sector.

Also, more people will likely buy homes given the lower interest rates.

While dragging down returns on yuan-dominated fixed-income products, the interest rates cut may help boost the performance of Chinese stock markets, especially with the launch of the Shanghai-Hong Kong Stock Connect.

Foreign inflows to Chinese stock markets can lead to more purchases of Chinese yuan, buffering the currency from the impact of selling.

Some bullish domestic securities firms say the interest rates cut gives one more good reason for international investors to buy relatively cheap Chinese stocks under the Shanghai-Hong Kong Stock Connect.

On Tuesday, the Shanghai Composite Index rose 1.37 percent after reaching a three-year high the day before.

But a possible stock rally may not necessarily advance the yuan against the dollar.

"Overseas inflows into Chinese equity market will not automatically push Chinese offshore yuan a spot higher," said UBS Chief China Economist Wang Tao.

She thinks many foreign institutional investors may choose to borrow rather than buy Chinese yuan to fund their purchases of Chinese mainland stocks.

"Not all flows into Shanghai equities will be foreign exchange-hedged -- only a portion will be. That, however, will still be enough to dilute any initial mutual-market-access-induced boost," Wang said.