EM: What Has Changed?

This is what has changed in the EM space, in our view:

1) China’s State Administration of Foreign Exchange (SAFE) announced new regulators that will curb the banking system's ability to short the US dollar

2) Chinese officials also indicated that they will be closely watching cross-border flows by importers and exporters

3) China’s State Council said it will unveil an operational plan this year to make the currency fully convertible on the capital account

4) Poland’s central bank surprised the markets Wednesday with a 25 bp cut to 3.0%

5) Bank of Korea delivered a dovish surprise Thursday, cutting rates for the first time since October 2012

6) Fitch upgraded Mexico to BBB+ with a stable outlook

1) China’s State Administration of Foreign Exchange (SAFE) announced new regulators that will curb the banking system's ability to short the US dollar (or other currencies, for that matter). Specifically, the quota for individual banks to short foreign currencies linked to their currency loan and deposit situation will be strictly enforced. Banks are given until the end of next month to comply. Previously SAFE simply set the quotas. Essentially, the Chinese banking system is seen having more foreign currency loans (short) than deposits (long). This would imply a need by local banks to buy foreign currencies, especially the dollar.

2) Chinese officials also indicated that they will be closely watching cross-border flows by importers and exporters. This is the flip side of the coin with regards to foreign currency imbalances for Chinese companies. This could result in a moderation of export growth in the period ahead, as more reports have emerged that export receipts have in recent months been overstated by many local companies in order to maintain excessive long CNY positions that would benefit from more currency appreciation. Some researchers estimate that as much as 2/3 of the 14.7% y/y rise in April exports are fictitious. Clearly, this would also overstate the implied strength of the economy and its implications for global growth and trade.

3) China’s State Council said it will unveil an operational plan this year to make the currency fully convertible on the capital account. It will also create a mechanism for outbound investment by individual investors. We shall see. They are certainly moving in this direction, but the time line will be the key here. We expect a very slow and steady approach to FX liberalization rather than any sort of “Big Bang.” PBOC continues to fix USD/CNY lower, today hitting another cycle low of 6.1925. The yuan has appreciated 1.6% YTD and 1.3% QTD against the US dollar, which is more than we expected. While it has not a very large move in the world of foreign exchange, we suspect that officials will seek to engineer a more stable tone in the coming weeks.

4) Poland’s central bank surprised the markets Wednesday with a 25 bp cut to 3.0%. Given that officials made such a show about pausing rate cuts, we thought that a June or July cut was more likely. Consensus was for steady rates at 3.75%, but analysts were somewhat split. We believe the easing cycle will continue, with another 50-75 bp of easing possible by year-end. EUR/PLN fell after the surprise decision but remains in the 4.10-4.20 range that has held for most of this year.

5) Bank of Korea delivered a dovish surprise Thursday, cutting rates for the first time since October 2012. The 25 bp cut takes the policy rate down to 2.5%. Governor Kim said that BOK considered rate cuts by the ECB and RBA in making its decision. In this case, the won weakened after the decision as officials continue to fret about the strong currency. The important JPY/KRW cross moved below 11 this week, while USD/KRW broke convincingly below 1100. We expect strong measures to combat won gains in the coming weeks, which we believe includes further rate cuts in 2013.

6) Fitch upgraded Mexico to BBB+ with a stable outlook. The big surprise was that it wasn’t S&P that upgraded, since it moved its outlook from stable to positive earlier this year. While we remain bullish on Mexico, perhaps the agencies are getting a little ahead of themselves since none of the really tough reforms have been passed yet. Our model rates Mexico A-/A3/A- compared to actual ratings of BBB/Baa1/BBB+, but we do not see single A status until oil and financial sector reforms have actually been passed. USD/MXN broke below the key 12 level after the upgrade Thursday, and that area should now provide strong resistance. We expect greater official concern about the strong peso if the pair moves convincingly towards our new target of 11.50.