Chinese yuan may weaken to 7 against dollar by year-end, Goldman Sachs says

Goldman Sachs says Chinese yuan may weaken

The Chinese yuan, the source of much anguish in financial markets from Sao Paulo to Singapore since last summer, is enjoying some respite.

The currency, also known as renminbi, is currently trading near its best levels against the dollar this year at 6.5241, having slumped to 6.5800 earlier in 2016.

Efforts by Chinese policymakers to shore up confidence in the economy have helped somewhat.

Capital outflows, a big factor behind the weakness in the currency and the subsequent depletion of China's foreign exchange reserves as the People's Bank of China (PBOC) intervened to prevent the yuan from falling more, also appear to have eased.

But Goldman Sachs still expects the currency to weaken to 7 against the greenback by the end of the year and has listed four reasons behind its call. Here they are:

Debt overhang

The sharp surge in credit in recent years has led to an accumulation of debt in the economy that will likely imply interest rates will stay lower for longer, Goldman Sachs estimates.

The softer monetary policy should add to depreciation pressures on the currency.

Economic slowdown

China's once-runaway export growth has slowed (shipments fell at their fastest pace since 2009 in February) as the currency has appreciated on a trade-weighted basis over many years.

Overall economic growth was 6.9 percent in 2015, sturdy by global standards but the slowest pace in China in 25 years.

Policymakers may now have to tweak the currency to counter the slowdown in the economy, Goldman reckons.

Preference for weaker currency

According to Goldman Sachs, the managed depreciation of the yuan in December and the early weeks of 2016 suggests "a degree of bias" on the part of the authorities for a weaker currency.

Goldman cites a recent interview given by PBOC Governor Zhou Xiaochuan to Caixin magazine, in which Zhou suggested that the current yuan level against the dollar did not represent a "reasonable and balanced" level for the currency.

Policy divergence

Goldman's U.S. team expects the U.S. Federal Reserve to raise interest rates three times this year, while forecasting economic growth to be above the trend level.

An increase in U.S. interest rates coupled with a downward trend in Chinese monetary policy will imply outflow pressures and lead to yuan weakness, Goldman says.

A customer holds a 100 Yuan note at a market in Beijing.
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The trend for further softness in the yuan has raised speculation on policy options for the PBOC, including a one-off devaluation in the yuan or a more steady weakness.

Goldman believes the second option is more likely as a chunky one-off devaluation would raise doubts over the credibility of Chinese policymakers and draw political attention at a sensitive time.

China's hosting the Group of 20 summit in September and U.S. presidential elections will follow a couple of months later. Not the time to be under scrutiny.

Large weakness in the yuan would also fuel inflationary pressures and undermine competitiveness of China's trade partners in emerging markets, Goldman believes.

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