Both the U.S. dollar and Japanese Yen caught a safe haven bid this morning on news that China wrote off three times more bad loans in the first half of the year. Investors are looking at the increase as a big red flag for Asia’s largest economy and while it reveals some of the country’s deeper problems, the write-offs are also part of the new government’s overall strategy to clean up their books and bring default ratios to international standards. Instead, we believe that the sell-off in risk can be blamed more on the People’s Bank of China’s decision to pass on injecting liquidity into the financial system for the second time since July 30th. The central bank generally injects liquidity twice a week but a surge in capital flows last month has discouraged them from doing so this week. As a result, the 7-day repo rate surged more than 100bp overnight to a high of 4.5% before settling at 4.05% on the day. Tighter liquidity at a time when the world is watching the pace of Chinese growth carefully has weighed heavily on Asian stocks, risk appetite and high beta currencies.
However with the record profitability of some of China’s largest lenders, now is the right time for them to take write-downs because profits can still be preserved and a deep sell-off in Chinese stocks can be avoided. There is no doubt that slower growth has increased the amount of bankruptcies and failed businesses but the Chinese government is pressuring its banks to take write offs now to avoid a surge in non-performing loans later. At the end of the day, this process will help to make Chinese banks healthier but in the near term, if Chinese banks set aside more funds to write off bad debt, it would also reduce liquidity, an outcome that would not be kind to high beta currencies.
No U.S. economic data released today but the Bank of Canada dropped its bias to raise interest rates, sending the Canadian dollar sharply lower. Their decision to leave rates unchanged at 1% was widely expected but their grim outlook for the economy caught many investors by surprise. By dropping the line that rates will need to be increased in the future and cutting their GDP forecasts for 2013, 2014 and 2015, the Bank of Canada is sending a very strong message to the market that they are worried about underperformance. The central bank sees a lower output level than previously projected with inflation risk escalating to the downside. The improvements that they were looking for in exports and investment have been delayed and as a result, there is sizable excess capacity in the economy. The BoC downgraded its forecasts for U.S. growth as well, which implies that their shift to a neutral bias is motivated by their concerns about growth inside and outside of their borders. Between the recent drop in oil prices and the Bank of Canada’s less hawkish bias, we believe USD/CAD is poised to break 1.04.