China's Fitch Downgrade And Thoughts On The Yuan

After the Chinese markets closed, Fitch announced it was cutting China's local currency long-term debt rating to A+ from AA-, with a stable outlook. The foreign currency debt rating was unchanged at A+, as Fitch cited its huge reserve holdings, which at the end of last year were near $3.4 trillion.

Why?
Fitch cited the rising risks to China's financial stability as the reason for the downgrade, which is generally appreciated by the professional investment community already. Fitch's move puts its rating in line with what the proprietary models of Brown Brothers Harriman emerging market currency strategy team.

The ratings agency noted that the stock of bank credit that has been extended to the private sector was near 136% of GDP at the end of last year, which Fitch says is higher than any other emerging market it tracks. In addition, when the shadow banking is included, the total credit extended may be near 200% of GDP. Fitch also noted that local government debt rose to 25.1% last year, up from 23.4% in 2011. Total government debt is now estimated at almost 50% of GDP.

Other Opinions
The other two major rating agencies rate China AA- (S&P AA- and Moody's Aa3). However, S&P's outlook is stable and Moody's outlook is positive. Some adjustment is possible, especially in terms of the outlook. We note that the Chinese government has been working towards boosting financial transparency and getting a better handle on the shadow banking system.

Separately, we see some commentary referring to the breakdown of the dollar and that yuan's correlation. We recommend taking such claims with more than the proverbial grain of salt. Those claims seems mistaken. It measures the dollar by looking at the Dollar Index, which is really more than euro and currencies that trade in the euro's orbit, which accounts for almost 2/3 of the basket and that does not include sterling (almost 12%), which as we noted Monday, is the least correlated with the euro in a decade.

Tight Control
Because the yuan's movement is so tightly controlled against the dollar (against which it is allowed to move no more than 1% from the fix and even this latitude is rarely explored) running correlations on percentage change is not very helpful. Analysts are forced to run the correlations on the level of the Dollar Index against level of the yuan, which is not a particularly rigorous approach.

The 60-day correlation on level shows an inverse relationship of almost -0.6. That means that over the past 60 days, the Dollar Index and the yuan moved in opposite directions 36 days. Given our earlier point that the Dollar Index is largely driven by the euro, it does not mean that the yuan is less linked to the dollar. Rather it suggests, the yuan is trading a bit looser against its basket, of which the euro is thought to play a significant role. The yuan has gently appreciated against the dollar since February 20. It has risen about 0.57% against the dollar. During the same period the euro has fallen 1.75% against the dollar (and the yen has fallen 5.35% against the dollar).