Daiwa: Why China’s currency could get wobbly

China's currency may be expected to stay relatively stable, but that's based on myths about the mainland economy, Daiwa said.

One myth was that currency depreciation wouldn't make sense as it would hit China's credibility and jeopardize efforts to internationalize the currency even as it was unlikely to boost exports much.

But Kevin Lai, Daiwa's chief economist for Asia ex-Japan and a yuan bear, said that any depreciation of would be aimed at protecting the central bank's balance sheet, with attempts to use the currency to boost export competitiveness likely playing second fiddle.

"Against a backdrop of capital outflows, fixing the yuan to the U.S. dollar at a certain level will require constant foreign-exchange intervention. Intervention involves selling U.S. dollars in exchange for its own money," Lai said in a note last week. "When a central bank buys back its own money, there is a contraction in its monetary base or high-powered money, which is essentially a massive monetary tightening."

That would run counter to the mainland's efforts to stimulate its slowing economy.

"The only way to avoid this tightening is to stop interventions or at least scale them down. That approach instantly leads to currency depreciation," Lai said.

The market has offered some indication that China's authorities were allowing the currency to weaken, based on the People's Bank of China's (PBOC) recent daily dollar-yuan fixes. The spot currency is allowed to move 2 percent in either direction from the fix level during daily trade.

On Tuesday, the PBOC set the dollar-yuan fix at 6.6950, or a five-year low for the Chinese currency, weaker than Monday's fix at 6.6843.

The yuan's weakness against the dollar comes as the mainland is facing a rush of funds heading for the exits.

China suffered almost $700 billion worth of capital flight in 2015, according to the Institute of International Finance. Beijing logged $100 billion per month in average currency outflow during November, December and January but the pace of outflows had tapered off in more recent months, with net foreign exchange sales by commercial banks at $12.5 billion in May, down from $23.7 billion in April and $36.4 billion in March, Reuters reported.

The surge in outflows late in 2015 sparked market concerns that China's foreign reserves weren't sufficient to stabilize the currency by buying yuan over the long term. In June, those reserves rose to $3.21 trillion, up $13.4 billion, but that's off a peak of $3.99 trillion in June 2014, according to Reuters.

Despite those outflows, many analysts expected that a financial crisis was unlikely, in part due to the country's high savings rate, but Daiwa's Lai said that was another myth.

He noted that before the Asian Financial Crisis in the late 1990s, many countries in the region had high savings rates as well.

"Long yuan is an over-crowded trade. It took 10 years for dollar flows to go in. All of a sudden, money wants to get out. Inflows supported massive domestic debt expansion. Outflows should therefore lead to a massive domestic debt contraction, unless the currency is let go," he said. "It seems we are talking about a set-up for another balance-of-payments crisis here."

Lai also declared that expectations that China would be protected from a debt crisis because its debt was "purely domestic" were another myth.

He said that dollar outflows would lead to a contraction of the central bank's reserves if the PBOC continued to stabilize the dollar-yuan exchange rate, which would in turn have a contractionary impact on domestic debt.

That's because for every dollar the PBOC receives as an inflow, it prints around 6-7 yuan, depending on the current exchange rate, and then injects the funds into the banking system, where it is "multiplied" as it is used to generate credit, Lai said. If that dollar flows out of the country, it would tighten domestic liquidity conditions.

China's large current account surplus of around $80-90 billion a quarter also wasn't likely to provide much help in supporting the currency, Lai said, calling expectations that the surplus would help to refill foreign-exchange reserves another myth.

A vendor holds Chinese Yuan notes at a market in Beijing.
Jason Lee | Reuters

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter