-Yes, but we see the risks currently as relatively low. Our base case remains a gradual devaluation to 6.90 against the USD at year-end.
--A domestic debt crisis could be one trigger, although the government appears to have the fiscal space to recapitalize the banks..
---A self-fulfilling panic by retail investors is another risk; tighter capital controls are more likely than a large devaluation in our view.
The group to watch here may be less large global investors and more the mass of Chinese retail investors. If they panic and rush to the exit, there simply wouldn’t be enough reserves to satisfy demand for US dollars. This could well become a second-generation crisis: if enough retail investors fear a crisis, it will be self-fulfilling. Of course, pinning down the timing of such an outcome is quite difficult. China bears have been calling for a hard landing for years; others have been forecasting a double-digit depreciation in the CNY since the second-half of last year. As is the case with all second-generation model dynamics, the crisis is not inevitable.
In the face of this risk, how might Chinese authorities react?
In our base case, China has both the ability and the determination to avoid a crisis, and likely will devalue gradually and modestly over the rest of this year. But it would be prudent to continue to keep close watch on these risk scenarios.
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